Fanhua, Inc. (NASDAQ: FANH)

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Fanhua, Inc. (NASDAQ: FANH) A Questionable Company with a History of Alleged Fraud, Potential 79-100% Downside

“The work that I’m doing now, it’s not for the faint of heart,” said Markscheid, who travels to China for board meetings from his home near Chicago, in Wilmette, Illinois, eight to 10 times a year. “I’ve been sued quite a few times.” -Stephen Markscheid, Independent Director of Fanhua since 2007, interviewed in a trade journal. Source: https://www.insurancejournal.com/news/national/2013/06/18/295902.htm

Market cap $1.7 billion ADV (3 mo) 240k shares EV/Revenue 2.4x Share price $26.15/ADR Short interest 1% to 2.4%, estimate1 EV/EBITDA 21.3x 52 wk high/low $36.83/$8.69 Borrow cost -91 bps/GC P/E 21.5x Target price $0 to $5.49/ADR Prices/valuations as of market close 8/24/18, per Bloomberg, Capital IQ, and our analysis.

THIS ARTICLE REPRESENTS THE CURRENT OPINIONS OF SELIGMAN INVESTMENTS CONCERNING FANHUA INC. (FANH). Funds and accounts managed by Seligman Investments currently have short positions in FANH and therefore stand to realize significant gains in the event that the price of its stock declines. Although Seligman Investments does not expect to announce in the future any changes to its opinion concerning FANH, that is subject to change at any time. Following publication of this article, Seligman Investments intends to continue transacting in FANH’s stock, and it may cover its short position and/or be long, short, or neutral at any time hereafter regardless of the views stated herein. This article is for informational purposes only and does not constitute investment advice or a recommendation to purchase or sell any particular security or to pursue any particular investment or trading strategy. Seligman Investments cannot guarantee that any projection or opinion expressed in this article will be realized. Seligman Investment’s opinions are based on the public information and sources cited in this article, but Seligman Investments cannot and does not provide any representations or warranties with respect to the accuracy of those materials. In no event shall Seligman Investments or any of its affiliates be liable for any claims, losses, costs or damages of any kind, including direct, indirect, punitive, exemplary, incidental, special or, consequential damages, arising out of or in any way connected with any information in this article.

Related parties and affiliates of Seligman Investments manage other funds and accounts aside from those managed by Seligman Investments. These other funds and accounts may have (i) a long, neutral, or short position in FANH’s stock or other securities and instruments and/or (ii) different opinions concerning FANH than those expressed in this article. In addition, such other accounts may trade in the same securities or instruments of FANH at the same time, in the same or opposite direction or in a different sequence as the accounts managed by Seligman Investments.

Summary Fanhua (FANH) is a Chinese company that trades in the US via an ADR. It resells life insurance through an agency/commission model via a network of sales agents, serving as an outsourced sales channel for sub- scale insurers. The company claims to have 631,000 sales agents, and has been characterized as “China’s leading independent insurance distribution channel” in a sell-side report.2

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Unknown to some investors, Fanhua was previously known as CNinsure (prior ticker: CISG), and now trades under a new name and ticker. The corporate name change may make it difficult for investors to discern the company’s checkered and turbulent past. CNinsure’s stock crashed in the wake of allegations of fraud, followed by an abrupt collapse in its growth rate and margins. The company went public in the US in 2007 and peaked in 2010 at $28/ADR, before falling to $5 after a research firm published a series of meticulously detailed reports, similar to reports that exposed companies such as Sino-Forest, Orient Paper, and others during the offshore reverse-merger wave earlier this decade. Shareholders alleged that the CEO and CFO engaged in “a fraudulent scheme and course of conduct that operated as fraud.”3

CISG became an abandoned stock and hovered between $5-8 for years, an impressive feat relative to the de-listings and bankruptcies among its cohort. The company then changed its name to Fanhua in December 2016. The name change initially had little effect, but the stock picked up steam when the company re-gained sell-side coverage by a prominent US bank in late 2017. As the company re-acquired a measure of institutional sponsorship and validation, the share price exploded. In the past year, the stock has risen from about $8/share to a recent high of $37 in June 2018 – a remarkable, parabolic move for a stock that until recently was orphaned and traded below the value of its cash for long stretches of the past seven years.4

Based on due diligence of SAIC filings and other public information, we are deeply concerned about the company’s business practices. We believe that these practices bear a worrisome resemblance to those alleged in 2010, and that they have intensified as the stock has recently plateaued. Our concerns center on the company transferring cash to insiders via related-party transactions; overstating the size of its operations; acquiring companies from undisclosed related parties in suspicious transactions; reporting questionable revenues and earnings, with sharply elevated receivables to a firm not disclosed as a related party; discrepancies between earnings and cash flows; involvement with individuals who have been sanctioned by regulators in Hong Kong or who are linked to companies with histories of embezzlement, de-listing, bankruptcy, or SEC prosecution; and high dependence on questionable partners/customers, in this case ones that are a focus of regulatory action in China.

Given FANH’s history and current dynamics, our target price is $5.49 per ADS, a 79% decline from its last close. We believe shares may be worth $0. The last time investors purchased stock at these levels, it declined 85%. We believe a similar outcome is brewing. In particular, we note further accounting discrepancies in the most recent quarter, reported last week on August 20, that lead us to question the reported results. Accounts receivable spiked and are up 52% year-over-year while total revenues are down 4%. The company reported rising margins and the highest EBIT and earnings in a year, yet operating cash flows are negative – red flags that typically appear near a tipping point.

A summary of our conclusions, as detailed in the following 79 page report:

• Fanhua, when it was still named CNinsure, was accused of fraud, after an independent research firm published various allegations in 2010/2011. We review these allegations in great detail, as they suggest patterns that investors can use to detect what is currently unfolding. Please note that we use both company names interchangeably in this report, as it is the same enterprise. (p. 7-15)

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

• The cast of players from the prior episode is still in charge or otherwise involved with the company. Our review of the timeline of events in 2010/2011 leads us to conclude that management has a long pattern of engaging in behavior that we believe most investors would find troubling. Recent events indicate, to us, that the team has failed to absorb the lessons of the last debacle.

• In the aftermath of the last episode, management attempted to take the company private in partnership with a private equity firm. The proposal was withdrawn a few months later. A Financial Times article at the time indicated the PE firm spent $10mm on due diligence and “uncovered things in the course of due diligence that led the firm to call off the deal” such as “accounting issues” and “discrepancies” in the books.5 (p. 16)

• The US bank that initiated coverage of Fanhua in October 2017 with an overweight rating – coverage that we believe was responsible for the stock coming back to life – abruptly suspended its rating, price target, and estimates on July 2, 2018, despite issuing six bullish reports in that span and as recently as May. No explanation was provided, except “due to policy reasons.” This is reminiscent of virtually the entire sell-side terminating coverage in the aftermath of the alleged fraud in 2010/2011. As far as we can tell, per Bloomberg and the company’s investor relations page, the only remaining firm covering FANH is CICC in China.

• We believe the company is grossly exaggerating its number of insurance sales agents, and hence its potential for growth. Sales force size and growth are the company’s most critical operating metrics, highlighted in virtually every press release and conference call since their IPO. Our analysis suggests that the actual size of its sales channel is a mere 1/20th of the reported number. We find this to be deeply troubling, as it is reminiscent of allegations raised in 2010, which centered on unsustainable and questionable practices related to its sales agents. We also note risks arising from the multi-level marketing element of Fanhua’s sales force, given the regulatory scrutiny that these structures are currently facing. (p. 17-23)

• A vast majority of the company’s life insurance revenue, approximately 80%, is derived from just two partners. Fanhua’s partners – effectively customers – are life insurers that supply and underwrite the policies that Fanhua distributes in exchange for commissions, which comprise most of its revenue. These partners are high risk. The financier who controls one was detained last year and awaits trial as part of an anti-corruption campaign, according to press reports in China as well as The New York Times. Another key customer – PICC – abruptly suspended business with Fanhua last year when its management came under government investigation. PICC was Fanhua’s largest customer at the time, comprising 27% of 2016 revenue. The loss of that revenue quickly wiped out Fanhua’s largest segment, crushing the company’s growth rate. Investors appear oblivious to the risk of Fanhua losing its two remaining core customers, and we caution that should either terminate like PICC, Fanhua’s business and stock would be heavily impacted. Furthermore, the fact that Fanhua is dependent upon two life insurers, ones that are sub-scale and with regulatory problems to boot, casts doubt on the investment case fueling the stock. If Fanhua is China’s leading independent insurance distribution channel, and if the Chinese life insurance industry is migrating to outsourced insurance distribution as the bull case

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

posits, why are more (and higher quality) life insurers not working with Fanhua? (p. 24-27)

• The China Insurance Regulatory Commission (CIRC), on October 1, 2017, banned certain high- risk “insurance” products, which were critical to FANH’s growth in 2017. As the company’s growth has slowed since the ban, we believe that company insiders have quickly resorted to the same self-dealing tactics that they used in 2010/2011. This behavior has become blatant in the last few weeks, and involves the co-founder selling approximately $250mm of stock to the company – via a related party that the company initially failed to disclose, and which it still denies is an insider or related party. We cannot recall a company transferring cash from the company’s balance sheet to the founder on this scale and in one transaction. (p. 28-35)

• Simultaneous with the related-party transaction above, management implemented a complex incentive scheme that we believe will enable further siphoning of cash to related party entities. This scheme is almost identical to one that they implemented in the past. We believe that this scheme, when combined with the $250mm related party transaction just announced with the founder, is likely to drain 91% of the company’s current cash balance. We also document a history of the company making loans to insiders so that they can purchase stock, and then not paying back the loans. (p. 36-37)

• Within days of the founder’s transaction being announced, the largest outside holder in the company, Fosun Industrial Holdings Ltd, registered to sell its entire stake (3.3mm ADR’s). Given the rapid timing, we suspect this holder was blindsided and is preparing to exit after realizing the magnitude of what just occurred. However, Fosun just as quickly went quiet, suggesting difficulty in completing the secondary. This is reminiscent of insiders filing a secondary on May 12, 2017 to sell 7.5mm ADR’s, when the stock was at $8, and withdrawing the registration statement six weeks later. Coincidentally, Fosun was also the largest outside holder in a company called Folli Follie (FFGRP GA), which claimed to have store locations in China that didn’t exist, and which was exposed as a fraud in May, followed by sudden de-listing within three weeks of the report by a short-seller.6

• Fanhua is a roll-up that has completed numerous acquisitions, mostly of other insurance intermediaries. It is our belief, based upon an ongoing review of these transactions, that these acquisitions are rife with related-party abuses similar to what we have observed in various US-listed offshore companies. We document one case in particular where Fanhua announced an acquisition of a company, yet failed to disclose that it was a related party owned by the founder. Our review of local Chinese filings indicates that the founder of Fanhua still owns the entity years later, suggesting that it was a fictitious transaction. The chart of the “acquired” entity’s ownership required tracing multiple layers of intermediate entities, leading us to believe that the structure was designed to make it extremely difficult to establish its true ownership. We believe that this example is merely the tip of the iceberg. (p. 38-40)

• Fanhua’s business structure is opaque, complex, and creates potential for abuse. We find the degrees of complexity notable, even when compared to other offshore companies with a VIE structure. Fanhua has a US-listed Cayman holding company, an array of intermediate

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

companies, variable interest entities, and special purpose vehicles in the British Virgin Islands and Hong Kong, sitting atop a maze of entities in China. We have grave concern as to the purpose of this structure, based upon an additional case of what we believe to be a related- party transaction. This transaction was accompanied by a second suspicious step, where CNinsure transferred six of its insurance subsidiaries into an entity 95% owned by the current CEO of Fanhua. (p. 41-47)

• The company’s board of directors contains people with backgrounds that we find troubling. One independent director of Fanhua has a history of being involved with companies where the stock has crashed due to fraud, embezzlement, bankruptcy, or SEC prosecution. We document one breathtaking example of embezzlement in particular ($40 to 120mm siphoned by the CEO), at a US-listed (now de-listed and bankrupt) Chinese company accused of fraud, where he was a board member and on the audit committee. In addition, we discovered regulatory action against a partner at a private equity firm closely involved during the company’s formation. This partner supervises the firm’s China investments, and Hong Kong regulators sought to ban him from serving as a director for a period of 15 years. This firm was the company’s primary early investor, and one of the largest holders at the IPO. (p. 48-54)

• Fanhua’s recent results – both revenue and earnings – are low quality and have high risk of being a mirage. Receivables have spiked while revenues have declined. The growth in receivables is driven by sharp growth in “other receivables,” comprised mostly of a “loan to [a] third party.” We have discovered that this “third party” is actually a related party which is not disclosed as one, which we find troubling as revenues driven by transactions with undisclosed related parties were a central feature of companies that failed during the offshore reverse- merger wave earlier this decade. We are also concerned about a $50mm loan facility that Fanhua granted to a mysterious entity in the British Virgin Islands called “Sincere Fame International Limited.” (p.55-61)

• We also note sharp discrepancies between operating income, earnings, and operating cash flows, which further cause us to doubt Fanhua’s reported margins and earnings. These discrepancies have accelerated in the most recent quarter. Divergences of this magnitude typically appear in the late stages of a situation, indicating difficulties in keeping reported results going, based on our experience. (p.62-63)

• We believe that investor optimism about Fanhua’s “new” business model is deeply misguided. The main reason that the stock has come back to life is because of enthusiasm about a transition in mid to late 2017 from distributing low margin, commodity auto and P&C insurance to reselling higher margin life insurance. After announcing this shift, the company quickly reported a spike in life insurance commissions in Q3 2017, validating the pivot in investors’ minds. On the heels of a commensurate resumption of sell-side coverage endorsing this story, a perfect storm led investors to bid up stock. We believe that the “strategic shift” from re-selling P&C insurance to life insurance is merely a cynical attempt to spin the abrupt loss of its largest P&C customer, PICC, in March 2017. PICC represented 45% of P&C revenues, and their exit crushed revenue in Fanhua’s largest division. This left the company with no other option except life insurance. We

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

also document a long history of the company announcing abrupt, new business model changes, with little to show for them. (p. 64-67)

• The recent operating results that led to a re-rating and resumption of sell-side coverage are likely to be fleeting and disappoint investors who extrapolate them, as they were based on selling high risk insurance products that were banned by the Chinese Regulatory Insurance Commission as of October 1, 2017. A wild west dynamic developed in Chinese life insurance, where insurers offered “fast-return” products that guaranteed high rates of return in a rapid time-frame. These products – which drove Fanhua’s growth and stock move from $8 to about $30 in months – were turbocharged investment products vs. traditional life insurance. Chinese insurers sold these “life insurance” products as a source of cash to fund M&A and other high risk activities. Regulators became alarmed at the obvious systemic risks and have begun cracking down aggressively on insurers and industry abuses. (p. 68-73)

• Given FANH’s history and current dynamics, our target price is $5.49 per ADS, a 79% decline from its recent close. We believe shares may be worth $0. Our target price is the average of three valuation methodologies. We do not believe that valuing Fanhua is a difficult exercise. The market tends to apply a punishing multiple when a company’s reported revenues, margins, and earnings lack credibility. As investors begin to grasp that the bull case for the stock is based on misguided assumptions, we believe the stock will revert to its historical range of $5-9, where it has traded for most of the last seven years. (p.74-78)

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

A detailed review of the alleged fraud exposed in 2010

Before detailing the abuses we believe are currently occurring at Fanhua, it is important to understand the company’s history of similar behavior in the past. By examining what occurred during the previous episode, investors can discern similarities and patterns in the playbook, and the potential for a similar outcome.

After going public in the US in 2007, CNinsure experienced rapid growth in revenue and earnings. Unfortunately, this seemingly impressive performance was predicated upon on an alleged scheme to inflate its financial results. After this scheme unwound, the company’s financial performance collapsed.

The company’s business model is to be an outsourced sales channel for other insurers. Hence, revenue growth depends on growth in the number of sales agents. Most of the agents they hire are independent agents. Such agents - especially good performers - are difficult to attract and retain. Competition among insurers is fierce. The critical importance of sales agent growth was highlighted in their IPO prospectus, as the second item under “Risk Factors” – a similar risk factor is listed in their current filings:

If we fail to attract and retain productive agents, especially entrepreneurial agents, our business could suffer.

A substantial portion of our sales of property and casualty insurance products and our entire sales of life insurance products are conducted through our individual sales agents, who are not our employees. [..] Some sales agents are more productive than others. Further, in recent years, some entrepreneurial management staff or senior sales agents of major insurance companies in China have chosen to leave their employers or principals and become independent agents. We refer to these individuals as entrepreneurial agents. An entrepreneurial agent is usually able to assemble and lead a team of sales agents. We have been actively recruiting and will continue to recruit entrepreneurial agents to join our distribution network as our sales agents. Entrepreneurial agents have been instrumental to the development of our life insurance business. If we are unable to attract, retain and build on the core group of highly productive agents and entrepreneurial agents, our business could be materially and adversely affected. Competition for agents from insurance companies and other insurance intermediaries may also force us to increase the compensation of our agents and in-house sales representatives, which would increase operating costs and reduce our profitability.

Source: Company filing, Form F-1/A

In order to persuade independent agents to work with CNinsure, and in an effort to avoid “increase[ing] operating costs and reduc[ing] our profitability” as mentioned in the last sentence of the risk factor above, CNinsure engaged in the following:

1. It created and promoted an equity compensation scheme for sales agents. To make the scheme sound more attractive, the company guaranteed the value of incentive shares and indicated that they could be converted into cash at any time. The company also said these shares would appreciate in value every year by 5%. Obviously, any equity plan that guarantees the value of shares, allows them to be converted into cash, and even promises appreciation in their value every year is suspect.

2. Agents holding more than a certain number of shares could purchase ownership in an entity called Finestart Holdings Limited. Agents were told that this entity invested in various CNinsure subsidiaries that were in the process of going public in the US, Hong Kong, or China.

In November 2010, OLP Global – a firm that conducts due diligence on Chinese companies – published a report outlining the impact of new regulations issued by the China Insurance Regulatory Commission

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

(CIRC). By limiting the use of equity incentives schemes, the report argued that these regulations would 1) impact CNinsure’s rapid recruitment of sales agents and undermine revenue growth, and 2) require CNinsure to increase cash compensation and hence increase its primary cost item: commission expense. Their report explained the ways in which equity schemes were being abused by insurance intermediaries (highlights added):

“Historically, insurance intermediaries in China (including CISG, Huakang and others) have provided equity incentives to insurance agents in the course of aggressive sales expansion. Equity incentives were offered to attract experienced agents from insurance companies as well as competitors. While share ownership aligns employees' financial interest with those of shareholders', equity incentive plans have been abused by insurance intermediaries. Examples of abuse include:

• Insurance intermediaries promised guarantees of future returns from the equity incentives given to its sales agents; • Under pressure to achieve sales targets that would yield bonuses in the form of equity incentives, insurance agents artificially inflated sales results by purchasing their own insurance policies using borrowed capital; • Insurance intermediaries offered equity incentives to clients as sweeteners to purchase insurance policies. • Potential impact on CISG. Based on our knowledge, CISG has been offering equity incentives to its insurance agents since the end of 2007. • We believe CIRC's new initiative to restrict the use of equity incentives will effectively slow down CISG's aggressive hiring of sales agents, which will indirectly curtail revenue growth….”7

On December 2, 2010, OLP published a second expose which indicated that CNinsure was withholding equity compensation owed to its sales agents. The end result was an under-reporting of commission expenses leading to a misleading picture of low costs, high margins, and high earnings.

OLP stated that “We believe CISG may have understated commission expenses and overstated net income by a meaningful amount. Based on our estimates, the accumulative cost associated with equity incentive shares is likely in the range ofUS$46 - US$61 million.”8 Given that CNinsure reported operating income of $52mm USD in 2009 and $69mm in 2010, representing an extraordinary 34% and 37% operating margin respectively, adding back the costs of equity incentives shares would have materially reduced margins and earnings.

OLP included a more explosive allegation as well (bold added is typically ours):

“CISG's agents appear to be holding shares in an entity that does not legally exist. According to CISG's presentation to promote equity incentives at CISG-hosted information sessions, Finestart Holdings Limited[], (CNinsure Employee Share Ownership Limited Co.) is a Hong Kong registered entity to hold equity shares. However, we are unable to verify the registration either in Hong Kong or in mainland China, leading us to believe that Finestart does not legally exist. We believe Finestart is a hoax that CISG management uses to withhold indefinitely part of its agents' compensation, allowing CISG to record less cash compensation and still incentivize agents to work harder and longer for CISG. We believe CISG's operating risks will likely increase and growth will likely be impacted, should any disruption occur among CISG's network of agents.”9

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

In reply to OLP’s allegations, CNinsure engaged in a campaign of aggressive, categorical denial. We document the first four forums by which they did so:

1. On November 22, 2010, the company held a conference call for its Q3 results. In response to a question, management stated that their compensation scheme was not an “not an equity program” and “that it’s more like a [mileage] kind of thing with the airline companies”:

“Because you know within CNinsure we have over the last two and a half years we have developed a system called a score card. It's more like a [mileage] kind of thing with the airline companies. Our mileage kind of program within our sales professional is to be a factor. They will be accumulating points and these points will be used for few purposes but mainly to support their commitment to work longer period of time with the Company because if they work more than two, even three years, there is a chance for them to swap these points with our future, with our options.

There are also chances for them, if they accumulate enough points, they will become full time employees of CNinsure. In their daily processing when they're accumulating enough points they will be enjoying part of a (inaudible) of doing business. That is to say they're underwriting, their back office support, will be giving a preferential treatment. So we [formed] this as a very positive way of encouraging our sales professional to work longer with the Company, being more dedicated and perhaps more importantly to ensure quality of their production. So I'm happy you mentioned this. I'd just like to clarify this point. We do have this mileage program. It's not an equity program. It's just accumulating points for the purpose of their benefits.”10

2. On Dec 3, 2010, the company hosted a special conference call to rebut the allegations, in which it categorized the allegations as “premeditated short selling activities,” “malicious,” “groundless,” “out of context,” “extremely reckless and irresponsible.”

-“First of all, the management has explained explicitly in the Q3 conference call, that the so-called incentive shift in CNinsure was nothing but scorecard for points.” […] “Based on what I just explained to the very nature of our scorecard program as well as according to the accounting principles, we don't think that CISG has understated its incentive related compensation cost or expenses. Neither, we believe that the company is overstating its net profit.”

-“Secondly, Finestart Holdings Limited which was regarded not, I quote not legally exist in Adele Mao's report was actually registered in British Virgin Island, BVI. Although, it is providing services to the employees and sales agent of CNinsure who wanted to purchase U.S. stocks. It is actually an independent company, which has no interest of any kind with CNinsure. Adele Mao without making any prior survey and investigation, regarded Finestart as a hoax and does not legally exist and accuses the management of cheating sales agent, which is extremely reckless and irresponsible.”

-“Next, in relation to employee equity holding company or Finestart Holdings Limited to our knowledge, it is an independent operating company and so as of which connecting the company to U.S. stock trading and providing our employees and sales agents with the U.S. and CISG stock trading services. After all well-facilitated channel for America stock trading is difficult to find in China, in Mainland China. We believe this is an effective way to help our employees and sales agents to share a slice of cake while the company is growing well. In fact, Finestart Holdings Limited would collect a full amount of investment funds from each participants [sic], before it makes all the collective money into the American stock

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) market. As far as we know, we think the portfolio of Finestart Holdings Limited, there is not only CISG stock, but also other stocks including Citibank et cetera. Finestart Holding Limited does legally exist and it is actually an asset management company with good operating track record.”11

During this call, management received a question and provided rambling, confusing, and contradictory statements relating to their relationship with Finestart, leading to this eventual exchange:

Matthews International — Analyst:

…I am concerned that the entity [Finestart] appears to be economically associated with CNinsure and serves as you mentioned a moment ago an important compensatory role within the Company not just for the subsidiaries that are being held by the venture capital company, but also by some of the active economic entities of the listed company.

And as such, I think investors would be keen to have a much clearer disclosure about the nature of this entity, its capitalization, its revenues and its costs and its — most especially its economic interests in any of the CISG subsidiaries and/or affiliates. And as a consequence, I would like to request that be presented during the upcoming investor forum. That's all I wanted to comment.

Yinan Hu — Chairman and CEO:

Thank you for this credit question but let me emphasize here, we don't have CNinsure does not have any economic interest with Finestart. Finestart as I explained serves as a channel or a way for some of the sales agents working for CNinsure to purchase overseas stocks.

We don 't have any other financial relations or economic relations [with Finestart]. What we haven't done is things we believe this kind of channel of buying overseas stocks including CISG stocks could be beneficial to CNinsure. This is why we didn't show our red light on this. But I can fully appreciate your request and concern here about [Finestart] there itself.

But I can truly appreciate your request and concern here about Finestart various sales. I will do my utmost to coordinate, to see Finestart could provide what you requested just now, during the Open Day in Chengdu, although I can't at this very moment guarantee that this definitely will happen.12

3. On Dec 6, 2010, the company issued a press release with “statements of clarification relating to some misunderstandings on CNinsure's sales agent incentive program and CNinsure's relationship with Finestart Holding Limited ("Finestart").” CNinsure completely denied OLP’s allegations and stated that its “so-called share incentive certificate of CNinsure is nothing but [sic] scorecard for points. The Company has never published any presentation on share incentive certificate. Any publication that describes CNinsure's scorecard system as share incentive is not in conformity with fact.” The release also stated that “Finestart is an affiliated entity of Chengdu Jingshi Investment Co., Ltd. Finestart does not have any interest or economic ties with CNinsure.”13

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

4. On Dec 10, 2010, the company held an Analyst and Investor Day, in which it repeated similar denials. OLP Global’s reply indicated that management was now actively attempting to delete content and “impede” their research:

“In our view, CISG management continued down the path of denial at the investor day, which was held in Chengdu last Friday (China time). While there has been overwhelming evidence available for public viewing pointing to the details of CISG's equity incentive plan, management continues to willfully conceal material facts from the investment community.[…] All our supporting documents are obtained from publicly available sources, however we have seen links being disabled and images deleted in the last 72 hours in what we believe to be management's attempt to impede our research.”14

Later in December 2010 and in January 2011, OLP Global issued additional reports with documentation supporting its allegations:

“We are publishing the core supporting documents behind our recent research report…These supporting documents (Appendix I & Appendix 11) are publicly available from the Internet and are cached copies of CISG's presentations to existing/prospective agents. We invite interested investors and analysts to review the details and judge for themselves whether CISG's so-called "scorecard" system is in fact an equity- based compensation plan.”15

These documents – some originating from CNinsure’s own servers – demonstrated that CNinsure’s equity compensation scheme – far from being a mere points scorecard as the company had asserted – “had been widely promoted to sales agents for years by the company’s senior management”16 and that their sales agents “have been willingly accepting compensation in equity for the very reason that CISG management has been adamantly denying — the cash conversion feature.”17 The follow up material also showed that Finestart, contrary to management’s assertion that “[i]t is actually an independent company, which has no interest of any kind with CNinsure,” was intertwined with CNinsure.18

The evidence presented in the OLP Report was in our opinion damning, and demonstrated that management’s categorical denials in its press release, conference call, and analyst day were simply not credible. Among the avalanche of evidence presented:

• A published article from Dec 2007 "CNinsure Announced Equity Incentive Plan, Convertible to Cash 5 RMB per Share at any Time," where a CNinsure management team said that "the equity incentive shares issued to agents not only can be cashed out upon invested entities going IPO, but can also be converted immediately into cash by selling the shares back to CNinsure at any time. For any equity incentive shares to be cashed out 'in advance,' CNinsure has promised to offer 5 RMB per share."19

• An article from March 2008 available on CNinsure's site, describing a meeting with over 20 general managers where they discussed CNinsure's equity incentive plan.” The piece indicated that CNinsure’s equity incentive shares “ have several features — they protect the principle and allow the appreciation of value, can be bought back under certain conditions, can be converted to start-up companies' shares. and can be converted to CISG shares.” 20

• A published March 2008 interview with the company’s co-founder and CEO, where he said “The advantage of CNinsure's equity incentive shares is that, as a publicly listed company, the

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

equity incentive shares that CNinsure agents hold have more guarantees to realize the value […] CNinsure's equity incentive shares represent equity ownership […]Entrepreneurs can sell ownership to CNinsure, in order to realize the added wealth of value appreciation.”21

• A published Aug 2009 article mentioning a speech given by the CEO, where he stated that the Company will “use equity incentives to share the value of the enterprise and ‘let agents make more money.'”22

• A piece posted on CNinsure’s website in March 2010 by one of their sales agents, where the agent described the motivation provided by the equity plan. "When I thought I was gradually losing interest in this job and giving up completely, there was a turn of event. The company launched equity incentive plan in 2007. […] According to our company's CEO assistant, Mr. Li Chengbin (one of the founders): 'the method of issuing equity incentive shares to agents will allow agents to not only earn commissions, but also enjoy the value of capital appreciation. […] I developed tremendous interest and enthusiasm for my job since then. […] For every new employee that joins the company, I tell them my commitment to the company and help them understand the… significance of equity incentive shares.”23

• Another piece posted on CNinsure’s website in March 2010, by an employee at a subsidiary, indicating that equity incentive shares could "be converted to cash" and that "senior management” visited to promote the plan. The piece named various members of the management team as those visiting as part of this promotional effort, including the co-founder as well as the head of the P&C unit, Chunlin Wang, who is the current CEO of Fanhua. The piece stated that executives "discussed the active participation [in] the plan among other [CNinsure] agencies throughout China."24

• An article posted on a subsidiary’s site in from November 2009, describing “a reward ceremony” where equity incentive shares were given out. “After the reward ceremony was the plan conversion from last month, with music in the background, everyone was so happy. Especially after I announced the names of another batch of shareholders, the audience erupted into thunderous applause…[…] With such low threshold, it is reflective of CNinsure's wish to let all agents share the wealth and let everyone hold equity shares. After the report, everyone will be rushing to grow the business and will be afraid to be left out by CNinsure's high-speed growth train."25

• An article posted on CNinsure’s site in October 2008 stating that “the intensity of equity incentive award accumulation plan has gradually increased. In order to allow agents in Hebei to understand the benefit brought by equity incentive shares more clearly and gain deeper understanding of the incentive model with equity shares…”26

• An article posted on CNinsure’s site in June 2010, by an employee titled “Yangzhou Fanhua Training Sessions for New Agents in the Red Hot Month of June”: “[E]quity incentive shares allow agents to obtain extra income from capital appreciation, in addition to the traditional commission fees. To maximize agents' income, (cash-out) methods include converting to stocks,

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

dividend distribution, converting to cash."27

• To eliminate any doubt despite the mountain of evidence above, OLP also included a Google- cached copy of a PowerPoint presentation, with CNinsure’s logos on each page titled "Let Agents Make More Money" that described “agents' compensation in the form of cash commission plus equity incentive shares.” OLP added that “At CISG's investor day, management stated that selected agents put together this poorly formatted document and challenged the accuracy of the information due to the formatting from a Google cached copy. We subsequently uncovered the original PPT presentation with the exact same content….and downloaded it from a public source. However, the link has been disabled and images have been deleted during the past 72 hours in what we believe to be management's attempt to impede our research.”28

• In stark contrast to management’s repeated denials that CNinsure had any relationship to Finestart, the slides in CNinsure’s own powerpoint presentation included graphics indicating the relationship between Finestart and CNinsure as well as images of Finestart documents such as a “Share Issuance Notice, Stock Acquisition Procedure and Implied Share Value Notice.”29 OLP further commented on “management stonewalling on our BVI request for information on Finestart”: “Due to limited disclosure from CISG management regarding Finestart, we had requested ownership information on Finestart from the company's BVI agent. We were informed that Finestart has not authorized the release of shareholder information, implicitly denying our request through its inaction. An obvious question comes to mind: If Finestart is truly an independent third party, as CISG claimed, then why would it withhold relevant information that could clarify key issues?”30

The Aftermath

As the market weighed OLP’s allegations of fraud versus CNinsure management’s explanations and denials, the rapid and sustained implosion of CNinsure’s stock left little doubt as to which side investors viewed as more credible.

CNinsure’s stock declined 20% within a month of the first OLP report, 45% within 5 months, and 75% within 11 months:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Bloomberg

Although the market rendered a swift verdict, CNinsure management continued with their narrative in a last ditch effort to sell the company. In May 2011, a few months after the scheme was exposed, CNinsure announced receipt of a “preliminary non-binding proposal letter” for a going private transaction at $19/ADS (vs. a price of around $14 at the time), with management partnering with two private equity firms, one of which was the largest holder at the time. Unfortunately for the company, the outside PE firm that would have joined the existing investors backed out of the deal in September 2011, after spending $10mm in diligence and becoming uncomfortable with what they had uncovered.31

The collapse of the deal was followed was a sudden reversal in the narrative that the company had promoted since their IPO, indicating that OLP’s original claims were correct: that the company’s program to aggressively hire sales agents was unsustainable as CIRC rules were about to crack down on abuses in the use of equity compensation; and that compensation expenses would therefore spike as the company had to rely on cash commissions, sinking growth and margins.

The company capitulated in the first earnings release following the collapse of their buyout proposal:

"Due largely to the prevailing macroeconomic turmoil, during the third quarter of 2011 the Chinese insurance industry witnessed a slow-down of insurance premium growth and, for the first time in the past decade, the life insurance sector experienced negative growth. This was a major challenge to our third quarter financial operations [..] As we implement these strategic moves, we may experience a slowdown in growth during the coming two to three years….”

Source: Company press release 11/21/2011, http://ir.fanhuaholdings.com/news-releases/news-release- details/cninsure-reports-third-quarter-2011-unaudited-financial-results

They further admitted that their sales agent hiring “model” was now unwinding:

"High inflation is expected to trigger profound changes to customer demand, sales and marketing models, the division of labor and the inherent growth drivers in the Chinese insurance industry. Against this backdrop, CNinsure is also at a critical junction in its existence. Historically, our business growth has

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) relied primarily on a people-driven sales model. However, with rising labor costs and operating expenses, this sales model and the sustainability of our long-term growth is increasingly under pressure.”

Source: Company press release 11/21/2011, http://ir.fanhuaholdings.com/news-releases/news-release- details/cninsure-reports-third-quarter-2011-unaudited-financial-results

The sudden reversal in the company’s growth rate and margins implies that their previous results were inflated by the scheme that OLP alleged. Revenue growth collapsed, as did EBIT margins. We show margins by quarter to indicate the speed of reversal once their strategy unwound.

Source: Company filings

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

As the stock collapsed, management attempted to take the company private in partnership with a private equity firm. The proposal was withdrawn a few months later after the due diligence failed.

On May 16, 2011, the company announced the receipt of a “preliminary non-binding proposal” under which management would take the company private in partnership with two private equity firms, CDH and Texas Pacific Group (“TPG”). The proposed transaction appeared to be insider-led, as CDH beneficially owned 34% of the company’s shares, according to the same release.

Source: http://ir.fanhuaholdings.com/news-releases/news-release-details/cninsure-announces-receipt- non-binding-going-private-proposal

A few months later on September 15, 2011, the proposal was withdrawn, triggering a rapid 40% drop in the stock to ~$6. A Financial Times article at the time indicated that TPG spent “about $10mm in due diligence” and “uncovered things in the course of that due diligence that led the firm to call off the deal,” according to “a source familiar with the transaction and with TPG.” The article continued that “accounting issues were a big factor in TPG’s decision to pull out of CNinsure, according to people familiar with the matter. There were discrepancies in the business agents claimed to book and the money actually coming in, these people add.”

Source: https://www.ft.com/content/897e2c84-1a6d-11e1-ae4e-00144feabdc0

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

We believe a repeat of the 2010/2011 debacle is likely, as Fanhua is once again misrepresenting the nature of its insurance salesforce – the linchpin of its strategy and the primary driver of its growth

The previous section of this report explained the scheme that Fanhua engaged in post-IPO, which eventually blew up the stock. The heart of that scheme concerned their salesforce. As explained at the outset, as an outsourced sales channel for other insurers, revenue growth is a function of growth in the number of sales agents. We quote from their most recent annual filing (highlights added):

If we fail to attract and retain productive agents, especially entrepreneurial agents, and qualified claims adjustors, our business and operating results could be materially and adversely affected.

A substantial portion of our sales of property and casualty insurance products and all of our sales of life insurance products are conducted through our individual sales agents, who are not our employees. […] If we are unable to attract and retain the core group of highly productive sales agents, particularly entrepreneurial agents, and qualified claims adjustors, our business could be materially and adversely affected. Competition for sales personnel and claims adjustors from insurance companies and other insurance intermediaries may also force us to increase the compensation of our sales agents, in-house sales representatives and claims adjustors, which would increase operating costs and reduce our profitability.

Source: Fanhua 20F

The number of sales agents is Fanhua’s most important operating metric. The importance of this metric is underscored by the fact that every earnings press release since their 2007 IPO has highlighted the total number of sales reps – and implied growth in the number over the previous period. The size of Fanhua’s sales force is at the heart of the bull case for the stock, as indicated in a recent sell-side report:

Agent headcount: One notable point in 1Q18 result should be the sales agent headcount trend. As observed in major life insurers’ 1Q18 results, adding sales headcount becomes increasingly difficult as very strict regulation not to sell short-term savings product from the year-beginning looks set to drive a drastic change in the distribution channel. (i.e., most of life insurers start to increase/develop their sales headcounts on the agent-based distribution channel). In that regard, the company’s sales headcount increase to ~579K persons (106% oya) looks an impressive datapoint. During the results call, management mentioned its optimistic view on continuing increases in the sales agent headcount to ~1 million by 2019-end. Given only China Life and Ping An Life have million-strong sales headcount forces currently, once this happens it will offer strong evidence to support the view on the distribution channel migration from exclusive sales agents to independent financial advisors (IFAs).

On a recent earnings call on May 21, 2018, the CEO, in comments translated by the head of investor relations, promoted the “rapid growth” in Fanhua’s sales agents as reflecting “the acceleration of the trend of the agents’ migration.” The company provides this as evidence of a structural change in the life insurance channel, from captive life insurance agents toward independent insurance resellers like Fanhua:

Chunlin Wang, CEO [Foreign Language]

Oasis Qiu, investor relations

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Secondly, number of registered sales agents reported solid growth. As of the end of the first quarter 2018, the number of registered sales agents increased by 73,000 quarter-over-quarter to approximately 579,000, representing a net increase of 20,000 to 30,000 each month. The rapid growth reflected the acceleration of the trend of the agents' migration to independent distribution channels and that Fanhua has become the best choice for agents who are committed to starting up their own business.

Source: Fanhua earnings call, May 21, 2018

However, we are struck by two anomalies:

1. The number of sales agents that Fanhua claims to have is so large, relative to its size and versus large insurance underwriters, that it defies common sense.

2. The number of sales agents began a sudden spike in 2015, after years of sluggish growth. The number has continued to grow parabolically over the last year, yet the implied revenue per rep remains at a negligible number.

The obvious conclusion that a reasonable person would draw, especially given the company’s prior history, is that the actual size of the salesforce is being mis-represented. Let’s review the data.

Source: Company filings and press releases

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Company filings and press releases

Several conclusions are obvious from the company’s own data:

• First, the number of reported sales reps was relatively stagnant from 2010 to 2015, and then exploded and increased 5x over the last three years. We find it peculiar that the reported number has grown dramatically over the last few quarters in particular, just as the stock has

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

come back to life and as investors look for reasons to remain bullish.

• Second, the company’s revenue has been flat to down since 2016, although the number of reported reps is 280% higher as of the most recent quarter. Clearly, the addition of sales reps is having no impact on the company’s ability to drive revenue. The company has stated that they added 399,000 new sales agents over this period, yet revenue actually declined.

• Third, revenue per sales agent collapsed over this period of purported sales agent expansion. It went from $5,200 per rep in 2015 to $848 per rep as of the most recent quarter. Obviously, an insurance reseller that generates $848 in revenue per rep per year doesn’t have a viable business model. Even if sales agents captured most of this number via commissions, it works out to less than 5% of average per capita annual income in Beijing.

We believe something doesn’t fit, and proceeded to examine competitor data to see if that sheds any further light.

Key stats Per agent Gross written Premiums and Premiums and Sales agents premium (CMB annuity revenue GWP per annuity revenue GWP per agent (000's) billions) (CMB billions) agent (CMB) per agent (CMB) (USD) China Life Insurance 1,580 354 507 224,051 320,886 48,133 Ping An 1,390 476 573 342,446 412,230 61,835 China Pacific Insurance 874 176 263 201,373 300,915 45,137 New China Life 348 109 108 313,218 310,345 46,552 Fanhua 579 4.2 N/A 7,254 N/A 1,088 Source: 2017 annual reports and press releases for each company. Fanhua doesn't officially report written premium but mentioned the following on their Q4 2017 earnings call on 3/12/18: "In 2017, we achieved RMB 4.2 billion on the life insurance premium…."

This data indicates that Fanhua’s numbers are unusual and present us with an anomaly:

One, the number of sales agents that Fanhua reports is strikingly high for a small insurance reseller, relative to the largest life insurance companies in China. Fanhua, with $628mm USD in revenue in 2017, has 40% the number of reported agents as China Life, which generated $100B USD in revenue. In other words, they reported 0.6% of China Life’s revenue yet are on track to have half as many reps. Fanhua claims to have 81% more reps than New China Life, which posted $22B USD revenue. A quick online search for “total life insurance agents in China” indicates that there are about 6.5mm total insurance agents in China, which means that a company with $628mm in revenue claims to have almost 1 out of every 10 agents in the country.32

Two, based on the premiums that Fanhua says its agents underwrite, the gross written premium per agent makes no sense. The number works out to only $1k USD per year – about 2 to 4% the productivity per rep compared to China’s key life insurance players.

Given the data we’ve analyzed above, our analysis points to an obvious conclusion: Fanhua is misleading investors about its salesforce yet again, and does not have 631,000 sales agents as it

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) reports. We find this to be remarkable, given that allegations around sales agent recruitment are what destroyed the company’s stock and credibility in the last go-around.

Fanhua did a special call a few weeks ago on June 18th, in which they were asked about the size of their sales force. When pressed, the CEO finally admitted that the company has only 25,000 sales agents that are active in selling life insurance – a mere 4.3% of the 579,000 highlighted in the Q1 earnings release [highlights added]:

Call participant Right. Okay. And if I could just ask one last quick question, really appreciate you taking these questions. The clarification is very helpful. Of the 579,000 sales agents that the company disclosed last quarter, [c]ould you discuss, again, what percentage were active and sold the policy last quarter and whether any of those rank-and-file agents will get to participate in the Fanhua Entrepreneurial Fund? Like will they be able to get shares? Or do they have to sell a certain number of policies every quarter to participate?

Oasis Qiu, head of IR [Foreign Language]

Chunlin Wang, CEO [Foreign Language]

Oasis Qiu, head of IR [translating for the CEO] Of the 570,000 sales agents, 50% of those are active in selling all types of products, including auto, life and all the nonauto P&C insurance products, et cetera. And of the 250,000 active sales agents, 10% of them are active in selling life insurance policies.

Source: Fanhua update call, June 18, 2018

We find this admission remarkable, and we believe it was missed by investors, perhaps because it was buried toward the end of a 9pm call, east coast time in the US. The company has basically exited its P&C business, so the agents the CEO mentions as selling anything except life insurance are irrelevant. The entire bull case rests up on the company’s transition to a pure life insurance intermediary model, with the size and rapid scaling of its sales force as the key driver of its future growth.

In the last year, investors have bid the stock from $8 to a recent high of $37 based upon this premise, yet that premise is based on sales agent figures that lack credibility. Fanhua’s press releases have pointed to parabolic growth in the size of its salesforce every quarter, culminating in a reported size of 631,000 reps in the June 2018 quarter. We have already shown – analyzing Fanhua’s own metrics and those of competitors – that this number is questionable. And now we have Fanhua’s own CEO, admitting just a few weeks ago, that the company has a mere 25,000 reps that are active in selling life insurance.

We find it useful to do another calculation. We averaged the gross written premium per sales agent across the four primary life insurers in China. That average is 270,000 GWP per sales agent, or $50,000. We then took Fanhua’s gross written premium for 2017, and divided this by the average to arrive at the implied number of actual reps, which could we characterize as “sales agent FTE’s.”

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

GWP per agent (CMB) GWP per agent (USD) China Life Insurance 224,051 48,133 Ping An 342,446 61,835 China Pacific Insurance 201,373 45,137 New China Life 313,218 46,552 Average 270,272 50,414

Fanhua 2017 GWP (CMB billions) 4.2 Implied number of actual active agents 15,540

Source: 2017 annual reports for each company except Fanhua, which doesn't officially report written premium but mentioned the following on their Q4 2017 earnings call on 3/12/18: "In 2017, we achieved RMB 4.2 billion on the life insurance premium…."

Of course, this calculation assumes that the average Fanhua sales agent is as productive as the average rep at the larger life insurance. In reality, Fanhua may be attracting inferior reps than the tier one life insurers, in which case the number of actual active agents may be higher. Either way, the discrepancies between Fanhua’s claimed number of sales agents and active sales agents versus those estimated by our analysis are massive:

Implied actual agents versus company reports and comments

700,000 631,000 600,000

500,000

400,000

300,000 -96% vs. reported # 200,000 -97% vs. reported # 100,000 25,000 15,540 0 Reported number of total Actual active agents per Implied number of actual agents CEO comments active agents

Source: Company filings and press releases. Reported number of total agents are as of 6/30/18.

We also note that China’s life insurance industry is highly concentrated. Based on our research, the top five insurers represent 52% market share, based on 2017 life insurance premiums. Agents working at the captive sales forces for China Life, Ping An, China Pacific Insurance, and New China Life have no incentive to leave a top-tier brand for a third-party distributor like Fanhua. Their top agents have a book of renewal business, built over many years, which they would lose if they left.

These switching costs relegate an intermediary like Fanhua to recruiting a self-selecting group of agents with high-risk characteristics. A Reuters article titled “Mis-selling risks grow with China’s insurance sale army” indicated that the hiring bar is low, that agents lack training or financial expertise, and that they

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) try to sell to family and friends, which sounds reminiscent of multi-level marketing systems. The report indicated that first year retention can be as low as 15-20 percent.

Source: https://www.reuters.com/article/us-china-insurance/mis-selling-risks-grow-with-chinas-insurance-sales- army-idUSKBN0TF2FP20151126

We have not investigated the structure of Fanhua’s sales force in detail, but we are troubled by a disclosure the company made in a 2009 press release, stating that “The CIRC has recently issued “Measures to Reform the Insurance Marketing System” […] According to the Measures, the CIRC aims to do away with the pyramid structure that is commonly used in organizing insurance sales agents….”

Source: http://ir.fanhuaholdings.com/static-files/67ea077e-8bcd-400c-9cda-230aa718f172

The press release is old, and we are uncertain whether “pyramid structure” refers to aspects that are similar to a multi-level marketing system. An article in the South China Morning Post linked the two practices: “Chinese pyramid schemes commonly practice “multi-level marketing” (MLM), a system whereby a salesperson earns money not just by selling a company’s goods but also from commissions on sales made by others, whom the first salesperson has recruited. People often earn more by recruiting others than from their own sales.”

Source: http://www.scmp.com/news/china/policies-politics/article/2108031/perils-pyramid-schemes-dark-corner- chinas-economic

Any similarities would pose additional risks for Fanhua’s business model, given regulatory action in China against abuses by multi-level marketing companies:

“In short, the PRC authorities are taking strong action against pyramid schemes. Serious misconduct on the part of a number of Chinese MLM companies has led to social unrest that in turn has spurred the PRC State Administration for Industry and Commerce, Ministry of Education, Ministry of Public Security and Ministry of Human Resources and Social Security to launch on 10 August 2017 a three-month national campaign to crackdown on illegal pyramid schemes in China (“Campaign”).”

Source: https://www.chinalawinsight.com/2017/08/articles/corporate/antitrust-competition/china-crackdown- how-does-it-impact-international-mlms/

We quote another article that discusses the prevalence of these structures in financial services products specifically:

“In large part, the growth of pyramids has been made possible by the internet, with a new generation of pyramids disguising themselves in such as way so as to be indistinguishable from the myriad other investment products available online in China’s huge and diverse financial ecosystem. Beyond the formal institutions of shadow banking that the foreign press generally focuses on – wealth management products, trusts, securities companies – there is an entire sub-tier of wealth management-style investment products being sold by investment companies, internet finance platforms, and financial exchanges, all promising high returns with low risk, normalizing investment behavior that is potentially quite dangerous.”

Source: https://macropolo.org/chinas-pyramids-promise-riches-deliver-curse-economy-slows/

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

The vast majority of the company’s life insurance revenue – approximately 80% - is derived from just two customers. If Fanhua is China’s leading independent insurance distribution channel, and if the Chinese life insurance industry is migrating to an outsourced insurance distribution model as the bull case posits, why are more life insurers not working with Fanhua?

The fact that Fanhua has two customers that comprise the majority of its life insurance revenue, and that these are questionable players, casts doubt on the entire investment premise behind the stock.

Fanhua’s 20F filed on April 20, 2018 indicated that it distributed life insurance for five companies:

The life insurance products we distributed in 2017 were primarily underwritten by Huaxia, Tian'an, Taikang Life Insurance Co., Ltd., Greatwall Life Insurance Co., Ltd. and ICBC AXA Life Insurance Co., Ltd.

The filing then states that the majority of this revenue was concentrated with Huaxia and Tianan, with each comprising 24% and 22% of total net revenues in 2017 [highlights added]:

We derive significant revenue from our important insurance company partners. Among the top five of our insurance company partners, each of Huaxia and Tian'an accounted for more than 10% of our total net revenues from continuing operations individually in 2017, with Huaxia accounting for 24.2%, Tian'an for 22.3% in 2017. As a result, any significant changes to our business relationship with the important insurance company partners could have a material impact on our revenue and profits.

Source: Fanhua 20F

The company’s reliance on Huaxia and Tianan has increased over the last two years. In 2015 and 2016, Fanhua depended on three large customers, but is down to two in 2017.

Source: Fanhua 20F

Note that the revenues presented above are as a percentage of total net revenue, not of life insurance revenue specifically. Only life insurance revenue is relevant going forward as the company’s P&C business has collapsed. In Q1 2018, life insurance represented 88% of the company’s agency revenue and 80% of total revenue, while P&C was down to 11-12% of both agency and total revenue.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Total life insurance revenue in 2017 was 2.4B RMB. Huaxia with 991mm RMB revenue in 2017 therefore represented 41% of Fanhua’s life insurance revenue, while Tianan with 913mm RMB represented 38%. In total, these two customers comprised 79% of Fanhua’s life insurance revenues.

Next, we examine the nature of these customers. We begin with Huaxia, Fanhua’s largest customer. In December 2016, China’s insurance regulator – the CIRC – banned Huaxia from selling new life insurance for three months. Huaxia appears to have been aggressive in using life insurance proceeds to play in the stock market.

Huaxia Life Insurance and Soochow Life Insurance have been prohibited from selling new life insurance products for three months and must suspend their online selling channels, the China Insurance Regulatory Commission said on Wednesday. It marks the latest regulatory move in the mainland to overhaul the universal life insurance business, which is seen as the major source of capital for unlisted insurers buying A shares aggressively.

Source: https://www.scmp.com/business/companies/article/2057697/huaxia-life-soochow-life-banned-launching- new-universal-life

On Oct 1, 2017, the CIRC also banned the sale of high-risk “life insurance” products of the type that Huaxia was selling. We discuss the critical impact of this ban on Fanhua in more detail later in this report. We remind investors that the alleged fraud that was exposed in 2010 also collapsed in the aftermath of new CIRC regulations to curb abuses at insurers. Those regulations addressed abuses in the use of equity incentives to attract agents, while the recent CIRC regulations ban the sale of risky products. The life insurance space in China appears to be like the wild west, with new abuses cropping up just as regulators address the previous ones.

Huaxia was highly dependent upon the sale of these high-risk products, indicating that they – and therefore Fanhua, as Huaxia’s distributor – are vulnerable due to the CIRC ban. One report implied that 75% of Huaxia’s revenue came from products targeted by the CIRC ban: “Huaxia Life grabbed headlines last year as China’s financial regulators cracked down on high-yield, short-term investment products like universal life insurance products, that are part insurance, part investment […] Huaxia’s universal life insurance division recorded…75% of [the company’s] total business, official data shows.”

Source: http://fortune.com/2017/07/05/missing-billionaire-tomorrow-holdings-xiao-jianhua/

A Bloomberg article titled “China Creates Own Insurance Monster” provided further color behind Huaxia’s rise:

For the last several years, China has allowed smaller insurance companies to flourish in the interests of creating competition for industry heavyweights such as China Life Insurance Co. and Ping An Insurance Co.

Sales of universal life products -- short-term, high-yielding investments that include a small insurance component -- boomed, with newer market entrants like Anbang Insurance Group Co., Huaxia Life Insurance Co. and Foresea Life Insurance Co. the main issuers. To fulfill the heady returns promised, those firms embarked on highly leveraged acquisitions, from hotels in New York to insurance assets in South Korea and Belgium.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Debt levels spiraled and before long, Beijing started to take steps to rectify the situation. In February, the China Insurance Regulatory Commission banned the chairman of Foresea Life from the industry for a decade, two months after it barred the company from selling all universal life products.

Source: https://www.bloomberg.com/gadfly/articles/2017-05-18/china-creates-own-insurance-monster

Huaxia Life is controlled by Xiao Jianhua, who appears to be a colorful “tycoon” based on Chinese press coverage. It appears his business empire is currently in a state of turmoil and dismantlement after an anti-corruption crackdown by the government. We quote an article from the New York Times titled “Employees of Missing Hong Kong Billionaire Are Barred from Leaving China,” which indicated that he was taken into police custody:

[…]

Source: https://www.nytimes.com/2017/02/13/world/asia/xiao-jianhua-hong-kong-china.html

An April 2018 article in the South China Morning post indicated that Xiao has been missing for 15 months and remains out of contact.33 Articles from late 2017 suggest that the government had forced Xiao’s conglomerate to sell a 25% stake in Huaxia, although the lack of follow-on press leads us to believe that the transaction never moved forward.

Either way, given that Huaxia was Fanhua’s largest source of life insurance revenue in 2017, representing 41% of its commissions, these developments should be sobering for investors in Fanhua’s stock.

Should Huaxia cease business with Fanhua, Fanhua’s life insurance revenues would collapse. For investors who think that this is a remote scenario, we note that PICC Property and Casualty Company was Fanhua’s largest customer in 2014, 2015, and 2016, representing 21%, 24%, and 27% of revenue in those years respectively. In 2016, reselling P&C/auto insurance was still Fanhua’s primary business, representing 76% of total agency revenue. PICC alone represented 45% of total P&C revenues.

On March 2017, PICC abruptly suspended business with Fanhua as PICC’s senior management “was being investigated by the government” (highlights added):

On March 1, 2017, our subsidiaries were notified verbally by PICC P&C's local branches that PICC P&C was temporary suspending its business cooperation with us on areas such as insurance agency, brokerage and claims adjustment because certain of PICC P&C’s senior management members was being investigated by the government. We derived 26.5% of our total revenues from PICC P&C in 2016 and had approximately 16.8% of our account receivables from PICC P&C as of December 31, 2016. [...] At this stage, we are unable to predict when and whether the business cooperation with PICC P&C might resume. Additionally, the government may request us and our management and/or employees to assist in the investigation against certain of PICC P&C’s senior management members, which would distract the management’s attention, might cause us to lose customers and other business

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) partners and eventually have a material and adverse effect on our business prospectus and financial results. Any prolonged delay in future settlement of the account receivables from PICC P&C may cause uncertainty on the recoverability Source: Fanhua 2016 20F filed April 19, 2017

We caution investors that should either Huaxia or Tianan abruptly suspend business with Fanhua as PICC did, Fanhua’s business and stock would likely collapse. Given what we have already described is occurring at Huaxia, we believe that this is far from a remote possibility.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

As Fanhua’s stock has plateaued in the aftermath of the CIRC regulatory ban, we believe that company insiders have quickly resorted to the same self-dealing tactics that they used in 2010/2011. This behavior has become blatant in the last few weeks, and involves the co-founder selling approximately $250mm of stock to the company – via a related party that the company initially failed to disclose, and which it still denies is an insider or related party.

On June 14th, 2018, Fanhua issued a press release announcing its “521 Development Plan.” The plan is complex, and we believe is an elaborate scheme to enrich insiders using related party entities. The transfer of value as detailed in the announcement would drain the vast majority of the company’s cash balance. Yet ironically, the opening paragraph of the release claims that “The board is confident this will further strengthen its cash generation capabilities and allow Fanhua to pay steady dividends.”

The plan involves setting up 3 different “funds” – Fanhua Fund A, Fanhua Fund B, and Fanhua Fund C – which in total will purchase 14mm ADR’s. The company currently has 65mm ADR’s outstanding, so this scheme would purchase about 22% of the company’s outstanding stock. The stock would then be granted to employees and senior management, almost entirely funded by loans from the company.

Source: Fanhua press release 6/14/18, http://ir.fanhuaholdings.com/news-releases/news-release-details/fanhua- announces-its-521-development-plan

The company has represented this to investors as an incentive program to motivate employees, while we believe it is merely a mechanism to enable insiders to sell stock to the company at inflated prices. It is also a mechanism for them to then transfer more of the company shares to themselves, which they can then dump. In effect, this creates two mechanisms for insiders to access the company’s cash balance:

1. Sell your shares back to the company at inflated prices. This avoids having to do a large secondary offering , which would crush the stock.

2. Then receive more shares from the company, using cash from the company structured in the form of loans. Whether the loans are likely to be ever paid back is an issue we’ll tackle later, based on management’s historical behavior.

This creates a circular scheme where management can periodically “buy” more stock using company cash in the form loans, and then sell that stock back to the company in exchange for more cash, and then rinse and repeat the above. We believe this is merely a spin on techniques used in reverse-merger

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) penny stock situations.

The company indicated that it expects to issue loans up to $365mm to participants in this plan to enable them to “purchase” the 14mm ADS’s that are part of the scheme:

Source: Fanhua press release 6/14/18, http://ir.fanhuaholdings.com/news-releases/news-release-details/fanhua- announces-its-521-development-plan

The implications are troubling.

• One, the company’s cash and equivalents balance as of the most recent quarter was $468mm, yet the company plans to make loans to three different entities (Fanhua Funds A, B, and C) in the amount of $365mm.

• Two, the company’s explanation that $365mm of outflows via loans will result in a (mere) net outflow of $177mm strikes us as specious, given that they expect the difference to be made up by money received by participants for the “purchase” of the shares. The company is asking investors to make the assumption that loans issued to Fanhua Funds A, B, and C will actually be used to purchase shares. Furthermore, the existence of significant inflows from plan participants is flatly contradicted by the opening of the press release, which implies that the vast majority of the share purchases by employees and management will be funded by loans, versus contributions by plan participants directly.

• Three, even if the company’s assertions are to be believed, why do they project ANY net cash outflows at all, much less the $177mm represented? If the company issues $10,000 in loans to an employee to purchase shares, the employee has to immediately remit $10,000 back to the company upon purchase. The net cash outflow to the company should obviously be zero. Why do does a cash outflow of $177mm even exist?

The unusual structure of the “incentive plan” and lack of details causes us grave concern. Why are shares being “purchased” by three “funds,” instead of by employees directly as it standard practice? Why is the company depleting its cash balance to fund an incentive plan, when companies typically just issue employees brand new shares at no cash cost to the company?

The company’s explanations lack credibility, and in our opinion the plan’s main purpose is to create a cover for insiders to enrich themselves by transferring the company’s cash. Our belief, based on management’s past pattern of behavior and in particular based on an analysis of a similar scheme they announced in 2014, is that issuing loans and shares to 3 new entities provides a vehicle for the type of related party fraud that is endemic within a subset of US-listed Chinese companies. We believe that these entities will be controlled by the founders and management of the company, for no purpose other than self-enrichment.

The company held a special update call a few days after announcing this plan, which appeared to be an effort at damage control. This reminds us of the ongoing clarification and update calls in the run-up to

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) the meltdown in 2010/2011. When asked why the company would deplete its cash to fund an incentive plan, versus issuing more shares as is typical practice, the CFO provided an absurd explanation (highlight added):

Call participant Okay. So I guess my follow-up question is, there is some kind of a cash impact to this transaction. Why not just conserve that cash and issue 8.5 million new shares instead? It's a bit unusual to use the cash to such an extent just to fund an incentive plan, right. Typically, companies just end up issuing new shares. I'm curious why the company didn't do that instead of having this incentive plan be such a significant use of cash.

Oasis Qiu, IR, interpreting for management [Foreign Language]

Chunlin Wang, CEO [Foreign Language]

Peng Ge, CFO [Foreign Language]

Oasis Qiu, IR Our CFO, Mr. Ge, will take this question.

Peng Ge, CFO [Foreign Language]

Oasis Qiu, IR The main issues that management would like to achieve our performance goals, our operational goals without undermining the interest of our existing shareholders. If all of the shares are newly issued by the company, they will call -- it will be a huge dilution to our existing shareholders. So by this way, by purchase some of the shares from existing shareholders and combining some new share issuance, it will enable us to provide better returns or better rewards to our shareholders in the future.

Source: Company update call, 6/18/18

In other words, the company has just announced an “incentive plan” involving the transfer of 14mm ADR’s - about 22% of the outstanding total, though a combination of cash outflows and dilution – yet the CFO is stating that it is structured “without undermining the interest of our existing shareholders.”

A more explosive component of this structure is buried later in the same announcement: of the 14mm ADS’s required to “fund” the plan, 8.5mm were actually purchased from “a principal shareholder” [highlight added]:

Source: Fanhua press release 6/14/18, http://ir.fanhuaholdings.com/news-releases/news-release-details/fanhua- announces-its-521-development-plan

This unnamed shareholder sold 8.5mm ADS’s to the company at $29/share, for a total of $247mm. Given that the company reported cash and equivalents of $468mm as of the most recent quarter the company is transferring 53% of its cash balance just to this seller. When this $247mm is combined with

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) the $177mm in net cash outflows associated with the “funding” of its “incentive plan,” our analysis leads us to conclude that the total drain on the company cash is $424mm – or 91% of the company’s latest cash balance.

Upon reading the release, we found it suspicious and unusual that a company would transfer $247mm of cash in exchange for a holder’s shares without even naming the shareholder. Other elements are suspicious as well. Why weren’t there any filings for this sale, given that the holder’s size would almost certainly require them to file with the SEC? Why didn’t the holder just do a secondary, versus being granted a highly unusual, selective, and expensive buyback by the company? Why weren’t other shareholders offered the opportunity to sell stock to the company, via standard mechanisms like a tender offer or a Dutch auction?

We immediately concluded that the transaction was a transfer of cash to a related party, almost certainly one or both co-founders, and that this unusual structure solved two problems. First, by selling stock back to the company versus on the open market, it prevented pressure on the stock price, given the magnitude of the stock sale. Second, it prevented the stock from crashing, which is often the case when promoters signal an intent to exit their stake.

Four days after the announcement of the new “incentive plan” and the purchase of stock from this unnamed shareholder, the company held what appeared to be an emergency call with investors to “discuss its 521 Development Plan.” The company attempted to explain the identity of the mysterious shareholder, which it failed to disclose in the original announcement. We quote from a transcript of the call on June 18, 2018, where the CEO’s comments are being translated by investor relations [highlight added].

Oasis Qiu, IR And the second question, I would like to give some background about the counterparty of the transaction for the purchase of 8.5 million ADS, Master Trend Limited.

Chunlin Wang, CEO [Foreign Language]

Oasis Qiu, IR Firstly, the seller of the 8.5 million ADS is Master Trend Limited. According to its latest filing on schedule 13G amendment, Master Trend Limited beneficiary owned an equivalent of approximately 10 million ADS of Fanhua, representing 15.46% of our total share capital as of -- date.

Chunlin Wang, CEO [Foreign Language]

Oasis Qiu, IR To our knowledge, Master Trend Limited is a Hong Kong registered investment company set up by Shenzhen [ CC ] Investment Co. Limited for overseas public act investment purpose. [ CC ] Investment is a PRC-registered and properly licensed private equity firm. Mr. Qiuping Lai is the principal general partner of [ CC ] Investment.

Chunlin Wang, CEO [Foreign Language]

Oasis Qiu, IR Mr. Lai is one of the earliest founders and former President of Fanhua. After his retirement from Fanhua in March 2016, he has not been engaged in any aspect of our business activities since then and is no longer an insider of Fanhua. No member of the board and no executive officer of Fanhua has any active interest or any other economic interest in [ CC ] Investment. The transaction between Master Trend Limited and the Fanhua Fund participants for the purchase of 8.5 million ADS is made independently and on an arm's length basis.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Chunlin Wang, CEO [Foreign Language]

Oasis Qiu, IR As for why we purchased the share from [ CC ] Investment, first of all, the scale of the transactions involved in the Fanhua fund is quite large. And there's no other third-party shareholder, either an individual or institution, that has enough shares of the company to meet our requirements in one transaction. If we buy the shares on open market, the purchase prices will be uncontrollable. [ CC ] Investment is willing to sell their shares to us because some of the private equity fund products have reached maturity, and they need cash to pay the investors. Besides, they would also like to lock in some of the profits.

Source: Company update call, 6/18/18

This call finally disclosed the identity of the shareholder, and provided the reason why we believe the company concealed his identity in the first place: Qiuping Lai, a co-founder of Fanhua and the largest holder prior this transaction , with 10mm ADS’s representing 15% of the company’s outstanding stock. Note that the 8.5mm shares that Qiuping Lai is selling comprise 85% of the holdings under his name.

The company made a number of claims on the call which we believe to be false or misleading.

First, the company claimed that the seller was actually a private equity firm called Master Trend Limited which “to our knowledge…is a Hong Kong registered investment company” and is a “PRC-registered and properly licensed private equity firm” run by the co-founder of Fanhua. We located the Hong Kong filings for Master Trend Limited, which appear to be those of a shell entity and exhibit no signs of an operational private equity firm. The filings indicate that Master Trend has share capital of precisely one Hong Kong Dollar with only one holder and one share outstanding, and that the entity’s registered office is the same as Fanhua’s law firm.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Hong Kong filing for Master Trend Limited

Second, the company claimed that the co-founder “has not been engaged in any aspect of our business activities since [retirement in March 2016] and is no longer an insider of Fanhua….[T]he transaction between Master Trend Limited and the Fanhua Fund participants for the purchase of 8.5 million ADS is made independently and on an arm's length basis.”(Source: Company update call, 6/18/18)

We find it absurd that the company still denies that Qiuping Lai is not a related party or insider, despite his being the largest holder of the company and receiving a preferential deal and transfer of $247mm of the company’s cash. According to his online bio (http://ir.fanhuaholdings.com/corporate- governance/management) , the current CEO of Fanhua, Chunlin Wang, began working with Qiuping Lai – the co-founder - in 1998 at the predecessor entities to CNinsure and eventually Fanhua, when he would have been approximately 27 years old. His entire career has been spent working for the founders. A reasonable person would conclude that he is a 20-year loyalist to Qiuping Lai and Yinan Hu, the other co- founder.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Aside from common sense, we believe that other evidence of Qiuping Lai’s ongoing role at the company is not difficult to locate. In 2017, Lai filed a 13G with an address identical to Fanhua’s – contrary to the CEO’s claim that Lai has not been engaged with “any aspect of our business since…March 2016”:

Source: SEC filing 2/13/17, https://www.sec.gov/Archives/edgar/data/1413855/000121390017001232/0001213900-17-001232-index.htm

Third, we believe the CEO misrepresented the rationale for purchasing $247mm of shares from the co- founder. In our opinion, the transaction was designed to enrich the co-founder, yet the CEO claimed on the call on June 18, 2018, that “there's no other third-party shareholder, either an individual or institution, that has enough shares of the company to meet our requirements in one transaction.” We find this absurd, given that the company could have easily done a tender offer or Dutch auction as is

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) typically the case with buybacks. The CEO further continued the claim that that they purchased shares from a “private equity” firm by saying that it’s “willing to sell their shares to us because some of the private equity fund products have reached maturity, and they need cash to pay the investors. Besides, they would also like to lock in some of the profits.” Qiuping Lai’s “private equity” firm appears to be nothing more than a shell entity and we have found no evidence of any PE-type activities for Master Trend Limited, which makes the CEO’s mention of “private equity fund products that have reached maturity” to be preposterous. Given that the firm also only has one share and one shareholder, we find his explanation that “they need cash to pay the investors” equally absurd, as there are no other investors in the firm.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

The “521 Development Plan” announced on June 14, 2018 mirrors a similar scheme that management implemented in 2014

The transaction just announced is merely the latest example of a concerning pattern. Management has a history of creating convoluted “incentive plan” constructs that we believe are nothing more than a cover to enrich themselves at the expense of investors.

In 2014, management announced a new share issue to employees, where 10% of the company’s shares would be issued to “companies established on behalf of the employees” – similar to the “employee companies” described in the recent announcement. The release was quickly followed by a clarification release the same day, presumably for damage control [highlights added]:

Source: Company press release 11/27/14, http://ir.fanhuaholdings.com/news-releases/news-release- details/clarification-cninsures-announcement-issue-new-shares-employees

A number of questions arise. Why were shares issued to “Employee Companies” instead of to employees directly? What are these companies called, how many are there, when were they created, and who actually owns and controls them? None of these details are provided in the announcement.

We suspect, based on management’s pattern of behavior, that they created shell companies in which to simply transfer stock to themselves. There is no record in the company’s cash flow statements for 2014 indicating proceeds from an issuance of stock equivalent to 10% of the company’s outstanding shares.

We find it helpful to examine events subsequent to this announcement. The above announcement was on November 27, 2014. On December 12, management decided to suddenly increase the shares in this plan by 50%, to 15% of the company’s share base, per a press release34. The announcement even added: “"The new share issue was enthusiastically received by our employees, as reflected by the significant oversubscription.”

On December 14th, management announced that the offering resulted in proceeds of $41.5mm to the company. The release added remarkable information missing in the prior two releases: the purchase of shares by employees was funded by loans the company granted to employees, in contrast to the original release about two weeks prior which represented the share issuance as a source of proceeds for “working capital and general corporate purposes” [highlights added]:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Company press release 12/17/14, http://ir.fanhuaholdings.com/news-releases/news-release- details/cninsure-announces-completion-new-share-issue-employees

We note other aspects of this transaction that are deeply troubling. Despite representing proceeds of $41.5mm from the share issuance, the company’s cash flow statement for 2014 shows no such inflow.

Source: Company earnings press release, 3/2/15, http://ir.fanhuaholdings.com/news-releases/news-release- details/cninsure-reports-fourth-quarter-and-fiscal-year-2014-unaudited

In addition, although the company indicated in 2014 that the loans would be repaid within two years, a disclosure in the company’s recent 20F filed on April 2018 indicated that repayment has been extended, this time to June 2018 [highlight added]:

In order to facilitate the purchase of shares by our employees as described above, we have granted a loan to Employee Companies. The loans bear interest at a rate of 3.0% per annum and is repayable upon the sale of the shares by employees, termination of employment or within two years, whichever comes first. The interest rate is determined with reference to fair market prices and therefore no interest-related compensation expense is recorded. The repayment of the loan was further extended to June 2018.

Source: Fanhua 2017 20F

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Fanhua is a roll-up that has completed numerous acquisitions, mostly of other insurance intermediaries. It is our belief, based upon an ongoing review of these transactions, that these acquisitions are rife with related-party abuses similar to what we have observed in similar US-listed offshore companies.

We document one case in particular where Fanhua, then CNinsure, announced an acquisition of a company, yet failed to disclose that it was a related party owned by the founder. Our review of local Chinese filings indicates that the founder of Fanhua still owns the entity years later, suggesting that it was a fictitious transaction. The chart of the “acquired” entity’s ownership required tracing multiple layers of intermediate entities, leading us to believe that the structure was designed to make it extremely difficult to establish its true ownership.

We believe this example is merely the tip of the iceberg. Our review of these transactions is ongoing, as we are currently tracing the ownership of almost 50 entities associated with various transactions the company has announced, by reviewing Chinese SAIC filings. We note one transaction from 2011 that we believe is representative of the company’s modus operandi, where the company announced the acquisition of two insurance agencies – Guangzhou Huajie Insurance Agency Co. Ltd. and Dongguan Zhongxin Insurance Agency Co. Ltd:

Source: Company press release 8/31/2011, http://ir.fanhuaholdings.com/news-releases/news-release- details/cninsure-announces-acquisition-two-insurance-agencies

The same release implied that the purchase price for these acquisitions was 25mm RMB each – approximately $8mm USD total at the time. As we were curious to determine the recipient of this consideration, we asked a lawyer in China to review Chinese filings for Guangzhou Huajie and map out its ownership. The chart we received back is remarkable in its complexity:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Qiuping Lai Chengchuang (Shenzhen) Chengdu Chuang Investment Yide Enterprise Co Ltd. Management Partnership Qiuping Lai Zhu Yong Sheng Qiuping Lai Chengchuang (Shenzhen) Investment Co Ltd. Chengchuang (Shenzhen) Qiuping Lai Qiuping Lai Investment Co Ltd.

Qiuping Lai Chengdu Chuangjiarui Enterprise Management Shenzhen Yingjiaan Partnership Investment Partnership Limited

Guangzhou Huajie Insurance Agency Co. Ltd.

Guangdong Nanfeng Enterprise Co. Ltd.

Source: Analysis of SAIC filings for Guangzhou Huaji Insurance Agency

After reviewing an array of entities four layers deep, we find the same 100% owner standing at the end of each entity chain: Qiuping Lai, the founder of Fanhua. This evidence establishes that the insurance agency which Fanhua acquired, Guangzhou Huajie, was in fact an “acquisition” of an undisclosed related party, and furthermore, that the founder of Fanhua still owns the “acquired” company, indicating that it was a fictitious transaction.

For the avoidance of any doubt, we matched the information found in Chinese filings with a 13G filed by Qiuping Lai in February 2017, which indicated in a footnote that he was the 100% owner of Guangzhou Huajie:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: SEC filing 2/13/17, https://www.sec.gov/Archives/edgar/data/1413855/000121390017001232/0001213900-17-001232-index.htm

We note other disturbing features of this transaction. Fanhua’s 20F for that year, in a disclosure buried on page 75, stated Guangzhou Huajie had revenues of only 1.5mm RMB – indicating a “purchase” price of 17x revenues for a company with operating income of -750k RMB, or a -50% operating margin. The press release for the transaction indicated the purchase price represented a multiple of 10X “their guaranteed net profits for 2012.”35 In other words, the company expected “guaranteed” net profits of 2.5mm RMB within a year for a company which did just 1.5mm RMB of revenue.

In addition, we note the almost identical financials for both “acquisitions” – Guangzhou Huajie and Dongguan Zhongxin. Notice that the revenues, operating income, and net income are basically the same for both 2010 and 2011 – a rather unusual coincidence. This leads us to believe that these were simply shell companies:

Source: Company 20F for 2011 filed 4/2012

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Fanhua’s business structure is opaque, complex and creates potential for abuse. We have grave concern as to the purpose of this structure. We base this concern upon another example of what we believe to be a related-party or fictitious transaction. This transaction was accompanied by a second suspicious step, where CNinsure transferred six of its insurance subsidiaries into an entity 95% owned by the current CEO of Fanhua.

We find the degrees of complexity in Fanhua’s business structure to be notable, even compared to other US-listed Chinese companies with a VIE structure. Fanhua has a US-listed Cayman holding company, a dizzying array of intermediate entities in the British Virgin Islands and Hong Kong, sitting atop a maze of entities in China. The structure is fluid over time:

2012 2015 2017

Source: Company 20F filings

We have grave concern as to the purpose of this structure, and whether the structure and ownership as represented is correct. We are currently reviewing every acquisition and major transaction the company has completed since its IPO. One of the first suspicious transactions that we noticed was announced in July 2010. This transaction involved the acquisition of a majority equity interest in an entity called InsCom Holding Limited, which owned 100% of Shenzhen InsCom E-commerce Co. We examine this transaction as we believe it is representative of others that are the focus of our ongoing investigation.

CNinsure agreed to pay 84mm RMB for 65.1% of InsCom. In addition, CNinsure transferred six of its affiliated insurance agencies to an affiliated subsidiary of InsCom in exchange for newly issued “preference shares” of InsCom. In case anyone was concerned about who controls InsCom – and hence the assets and cash flows of the six subsidiaries that CNinsure just transferred into it – the release noted that the preference shares entitle CNinsure to “all of the profits of InsCom for a certain period….” (underline is ours). We paste the original release, as the wording is precise and important [highlight added]:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Company press release 7/29/2010, http://ir.fanhuaholdings.com/news-releases/news-release- details/cninsure-announces-expansion-e-commerce-insurance-business

This transaction struck us as interesting and suspicious. Why were six subsidiaries transferred for no cash, and only for “preference shares”? Who really controlled InsCom, the entity that was about to receive 84mm RMB (about $13mm USD at the time) of cash? Why did the preference shares entitle CNinsure to InsCom’s profits for only a “certain period,” and why was the length of that period omitted?

We speculated what we would do if we were insiders who wanted to enrich ourselves. One way would be to capture the cash flows of these subsidiaries, by transferring them to entities that we actually control.

We began by examining the 20F filed the following year, for more detail on this transaction. The disclosure is complex, and we believe it is written to be impenetrable. The beginning of the disclosure states that InsCom Holding – the entity being purchased by CNinsure for $13mm – had two shareholders. These two shareholders presumably received the $13mm in cash [highlights added].

In July 2010, CISG Holdings, our wholly owned subsidiary incorporated in the British Virgin Islands, entered into a Subscription and Shares Purchase and Shareholders Agreement, or the First Agreement, with Apollo & Muse Holding Ltd., or Apollo, and Clever Star Holdings Ltd., or CSH, the then two existing shareholders of InsCom Holding, a company incorporated in British Virgin Islands which beneficially owns 100% of the equity interest in Shenzhen InsCom, a limited liability company incorporated in the PRC. Under the First Agreement, Apollo agreed to sell its 6,588 ordinary shares of InsCom Holding to CISG Holdings at a consideration of RMB84,000,000 (US$12.7 million).

Source: Company 20F filing

However, three paragraphs down, we learn that there are two additional shareholders of InsCom Holding, contradicting the opening of the disclosure which implies that there are only two in total. These additional shareholders were identified as Cayman Islands entities:

Under the First Agreement, upon completion of the equity transfer, the board of directors of InsCom Holding will consist of three members, two of whom will be appointed by CISG Holdings and the other by Apollo. Constitution of the board of directors of each of the subsidiaries shall be the same as InsCom Holding and all directors shall be appointed as directors of the subsidiaries unless otherwise agreed by InsCom Holding. CISG Holdings has the right to select the CFO and the relevant executive officers handling the finance and accounts of

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

InsCom Holding. CISG Holdings agreed that if there are no capital raising events, such as an initial public offering or a sale of the majority of assets to an unrelated third party, within three years from the completion of the First Agreement, each of Apollo and two other shareholders, Wang Strategic Capital Partners (II) Limited, or WSCP, an exempted limited liability company incorporated under the laws of the Cayman Islands, and Harbor Pacific Capital Partners I, LP, or HPC, an exempted limited partnership registered in the Cayman Islands, shall have the right and option to put to our chairman and require our chairman to purchase or to cause any of his affiliates or to procure any third party to purchase all of the shares held by Apollo and those two shareholders at a specific price.

This additional information implies that the purchase price for InsCom Holding flowed to four different entities: two mysterious entities in the British Virgin Islands (Apollo & Muse Holding Ltd. and Clever Star Holdings Ltd) and two entities in the Cayman Islands (Wang Strategic Capital Partners (II) Limited and Harbor Pacific Capital Partners I, LP).

Beneficial ownership for BVI entities is impossible to obtain, but we located basic registry information for Inscom Holding (the acquired company), as well as for Clever Star and Apollo & Muse (the sellers).

It turns out, remarkably, that InsCom was only incorporated as an entity on July 5th, 2010:

Source: BVI Registry of Corporate Affairs

In order to understand the significance of this information, we repeat an excerpt from the company’s filings [highlights added]:

Source: Company 20F filing

In addition, the entities listed as the sellers were also incorporated at the same time. Clever Star was formed and incorporated only on June 7, 2010, and Apollo & Muse on July 5, 2010.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: BVI Registry of Corporate Affairs

In other words, InsCom Holdings, as well as the two entities that owned it, were formed either a few days or weeks before or simultaneous with the acquisition by CNinsure.

We also examined Wang Strategic Capital Partners and Harbor Pacific Capital Partners, names which sound like private equity firms and ought to leave some traces.

Yet, we could locate no meaningful information about Wang Strategic Capital Partners, which leads us to believe that it was merely a shell entity or personal vehicle. In 2014, the Cayman Islands Gazette published a liquidation notice for the entity:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: http://www.gov.ky/portal/pls/portal/docs/1/11526135.PDF

For Harbor Pacific Capital Partners, the email domain in the signatory section of one of the exhibits is listed as “@harborpac.com.” When we visited that domain name, it is inactive and currently for sale. An online search reveals multiple addresses for the firm over the years, some of which appear to be residential addresses in California. A LinkedIn search revealed the name of the principal, and the profile leads us to conclude that Harbor Pacific is a personal vehicle for an individual belonging to a wealthy Hong Kong family.

The mysterious nature of the shareholders of InsCom and the lack of disclosure as to what was actually being acquired causes us concern about the $13mm payment associated with this transaction. This concern is compounded by the six subsidiaries that CNinsure transferred to InsCom as part of the transaction. We parse another disclosure in the same 20F:

We subsequently undertook a restructuring by transferring the beneficial equity interests in six PRC affiliated companies, Henan Fanhua Anlian Insurance Agency Co., Ltd., Hangzhou Fanhua Zhixin Insurance Agency Co., Ltd., Tianjin Fanhua Xianghe Insurance Agency Co., Ltd., Fujiang Fanhua Guoxin Insurance Agency Co., Ltd., Changsha Lianyi Insurance Agency Co., Ltd. and Ningbo Baolian Insurance Agency Co., Ltd., held by CISG Holdings to Ying Si Kang Information, a wholly owned subsidiary of InsCom Holding incorporated in the PRC, or its associated companies in the PRC. In November 2010, CISG Holdings completed the transfer of its beneficial equity interests in five of the aforesaid six PRC companies to Xinbao Investment, an affiliated entity of Ying Si Kang Information. The equity transfer for the remaining PRC company is expected to be completed in the second quarter of 2011.

Source: Company 20F

There is no rationale provided in this disclosure for transferring six subsidiaries into InsCom. Moreover, the disclosure clarifies that the subsidiaries are actually being transferred into “Ying Si Kang Information, a wholly owned subsidiary of InsCom Holding incorporated in the PRC, or its associated companies in the PRC.”

The disclosure then adds that after transferring these six companies in July 2010, they were transferred again in November 2010 to another entity: “In November 2010, CISG Holdings completed the transfer of its beneficial equity interests in five of the aforesaid six PRC companies to Xinbao Investment, an affiliated entity of Ying Si Kang Information.”

We are left to wonder about the two new entities in mix: Ying Si Kang, and Xinbao Investment. As we examined these two entities, we found it interesting that of the myriad exhibits filed to this 20F, a large number involved agreements between Chunlin Wang and Xinbao Investment. Recall that the second step of this transaction involved transferring six subsidiaries of CNinsure into Xinbao. Chunlin Wang at

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) the time was an executive of CNinsure, and is currently the CEO of Fanhua. His biography on Fanhua’s website states that he has been involved with Fanhua’s predecessor companies since 1998, ran the P&C division, served as assistant to the chairman, and became CEO in October 2011. In other words, he has been intimately associated with Fanhua’s founders for 20 years.

We belabor Chunlin Wang’s role and history for one reason: because the six subsidiaries that the company transferred into InsCom were actually transferred via a multi-step transaction into Xinbao Investment, and Xinbao Investment was an entity 95% owned by Chunlin Wang, the current CEO of Fanhua. We located this information in SAIC filings for Shenzhen Xinbao Investment Management Co. Ltd:

Chunlin Wang 95% Source: SAIC filings for Shenzhen Xinbao Investment Management Co. Ltd.

For the avoidance of doubt, we located confirmatory information in exhibit 4.22, buried deep within the same 20F:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Exhibits filed with company’s 20F filing

Admittedly, the company could characterize the transfer of six subsidiaries as a typical transaction within a VIE structure common to US-listed Chinese companies, where insiders own an entity but execute agreements providing the company with contractual control. However, we still note the potential for abuse, especially given the following: the suspicious formation dates for Inscom Holding as well as Clever Star and Apollo & Muse; the fact that these six subsidiaries were being transferred simultaneous with that transaction; and the odd, multi-step nature of the transaction, where the subsidiaries were transferred to Ying Si Kang Information, only to be re-shuffled a few months later into Shenzhen Xinbao.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

We are troubled by Fanhua’s involvement with individuals who have been sanctioned by regulators in Hong Kong or who are linked to companies with histories of embezzlement, de-listing, bankruptcy, or SEC prosecution.

In our experience analyzing these situations, we typically notice certain patterns. We begin by analyzing the background of Stephen Markscheid, who has been an independent director of the company since 2007. Based on his LinkedIn biography and his background as explained on his personal website, he appears to have a particular focus on assisting Chinese companies that list in the US. In the research that follows, we emphasize that we make no allegation that Markscheid has committed any wrongdoing.

We first noted an interview that he gave to Insurance Journal in 2013, when the era of reverse merger frauds was still in swing in the US markets. The article was titled “IPO-Seeking China Companies Pay More to Avoid Boards Going Naked.” It stated that Markscheid held “one of the riskiest jobs in the world” according to insurers who provide directors and officers liability coverage. The article indicated that he sat on the boards of five US-listed Chinese companies:

The group of about 500 Chinese firms came under scrutiny over the past two years as a rash of accounting scandals and irregularities sent shares tumbling, sparked investor lawsuits and halted new stock offerings on U.S. exchanges. The U.S. Securities and Exchange Commission has revoked more than 50 Chinese company registrations since early 2011.

Source: https://www.insurancejournal.com/news/national/2013/06/18/295902.htm

On his personal website, he mentions his governance and audit experience as an independent director of six US-listed Chinese companies:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: https://stephenmarkscheid.com/#section-expertise

We compiled a list of companies and entities he has been involved with, using his LinkedIn profile (https://www.linkedin.com/in/stephenmarkscheid/). In analyzing what occurred at these companies, we begin with ChinaCast Education (ticker: CAST). His LinkedIn bio says he was an independent director from October 2011 to September 2017.

Source: https://www.linkedin.com/in/stephenmarkscheid/

According to ChinaCast’s press release announcing his appointment, he served on the audit committee:

Source: https://www.prnewswire.com/news-releases/chinacast-education-corporation-expands-board-of-directors- 130962603.html

We find it interesting to examine what occurred at ChinaCast during his tenure as a board member. In short, ChinaCast quickly became one of the more notorious China frauds of the era:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: https://www.law360.com/articles/718434/9th-circ-revives-suit-over-chinacast-ceo-s-120m-fraud

The Securities and Exchange Commission charged the former CEO with embezzlement, and provided details into the mechanism, which involved siphoning money into undisclosed related parties [highlights added]:

Washington D.C., Sept. 26, 2013 — The Securities and Exchange Commission today charged the former CEO of an education services provider based in China with stealing tens of millions of dollars from investors in a U.S. public offering, and charged another executive with illegally dumping his stock in the company after he helped steal valuable company assets. The SEC alleges that ChinaCast Education Corporation’s former CEO and chairman of the board Chan Tze Ngon illicitly transferred $41 million out of the $43.8 million raised from investors to a purported subsidiary in which he secretly held a controlling 50 percent ownership stake. From there, Chan transferred investor funds to another entity outside ChinaCast’s control. Chan also secretly pledged $30.4 million of ChinaCast’s cash deposits to secure the debts of entities unrelated to ChinaCast. None of the transactions were disclosed in the periodic and other reports signed by Chan and filed with the SEC. The SEC further alleges that Jiang Xiangyuan, ChinaCast’s former president for operations in China, avoided more than $200,000 in losses by illegally selling approximately 50,000 ChinaCast shares after participating in the ownership transfer of one of company’s revenue-generating colleges before it was publicly disclosed by a new management team. ChinaCast had a market capitalization of more than $200 million before these alleged frauds came to light. After Chan and Jiang were terminated and their misconduct was publicly disclosed by new management, ChinaCast’s market capitalization dropped to less than $5 million. “The massive fraud perpetrated by Chan destroyed hundreds of millions of dollars in market value, and Jiang’s brazen insider trading allowed him to profit by dumping his own shares on the market before the fraud was exposed,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office. Source: https://www.sec.gov/news/press-release/2013-200

ChinaCast had already been de-listed for failing to submit a 10K, and in 2016 the company filed for bankruptcy. The stock tells the story:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Bloomberg

We examined other companies Markscheid has been involved with and leave it investors to judge what his involvement with a company may or may not signal or predict, and whether there are any similarities between events at these companies and what we have documented in our research on Fanhua:

-China Integrated Energy (ticker: CBEH), independent director April 2011 to May 2014. The stock was de- listed after being exposed as a fraud:

"In this report, we present irrefutable evidence that China Integrated Energy (NASDAQ: CBEH) is 1) transferring company funds to management insiders through fraudulent sham acquisitions and 2) fabricating its SEC financial statements. CBEH has transferred at least $35 million dollars of company cash by making acquisitions of shell companies owned by Gao Bo, who is the firstborn son of the CBEH’s CEO, Gao Xincheng. Given that the company has made over $134 million dollars in acquisitions and lease “prepayments”, our research has uncovered only a small fraction of the total amount being stolen from shareholders. There is also strong evidence that the financial results of all three segments of the company, refined products distribution, biodiesel, and gas stations, are overstated or even fictitious.”

Source: https://www.zerohedge.com/article/china-integrated-energy-cbeh-latest-alleged-chinese-fraud-true- value-076share

-China Ming Yang Wind Group (ticker: MY), independent director from 2011 to June 2016. The stock went from about $14 to $1.50 within 14 months of IPO. A short-seller alleged various red flags similar to other China frauds: “oral agreements with related parties,” “interest-free advances to related parties,” “a loan guarantee that doesn’t make sense,” ”selling equipment to itself,” etc. source: https://glennchan.wordpress.com/2013/10/13/china-ming-yang-my-another-chinese-stock-to-short/

--Ener-Core Inc. (ticker: ENCR), independent director June 2016 to present. A reverse merger where the stock has declined from about $75 to 18 cents in 5 years, and 95% since his joining the board.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

-Hexindai (ticker: HX), independent director September 2017 to present. A US-listed Chinese peer-to- peer lender. The stock opened trading at $15 on its IPO on November3, 2017 and has declined 43% since. We note a recent article from Bloomberg titled “Panic Roils China’s Peer-To-Peer Lenders”:

China’s savers are rushing to pull money from peer-to-peer lending platforms, accelerating a contraction of the $195 billion industry and testing the government’s ability to maintain calm as it cracks down on risky shadow-banking activities.

In some cases, savers are turning up at the offices of P2P operators to demand repayment, spooked by reports of defaults, sudden closures and frozen funds. At least 57 platforms have failed in the past two weeks, adding to 80 cases in June, the biggest monthly tally in two years, according to Shanghai-based Yingcan Group. The researcher defines failed platforms as those that have halted operations, come under police investigation, missed investor payments, moved into other businesses, or had operators flee with client money.

Source: https://www.bloomberg.com/news/articles/2018-07-16/panic-roils-china-s-p2p-lenders-as-savers-rush-to- withdraw-cash

In addition to Markscheid, we examined the backgrounds of other individuals with a history of involvement with the company. In a press release on September 18, 2017, the CEO of Fanhua, Chunlin Wang, wrote a “Letter to Shareholders” in which he thanked two individuals from the Cathay Funds:

Source: http://ir.fanhuaholdings.com/news-releases/news-release-details/fanhua-announces-change-chairman- board

CNinsure’s 2010 20F states that in 2001 Cathay Capital Group “subscribed for 40% of the equity interests” of a BVI company which then incorporated CISG as a holding company, and that in 2004 Cathay subscribed for 28% of the new holding company’s equity. A holder’s search shows that New China Capital, the manager for Cathay, was one of the largest holders at the IPO. Given Cathay’s role as a critical, early backer of the company, it is not surprising that the CEO thanked Paul Wolansky and Hermann Leung of Cathay in his letter last year: “Without your trust and support, Fanhua would not be able to achieve what it has accomplished today.”

A CNinsure press release dated May 22, 2008 indicated that Wolansky had been a board member since 2004 and stepped down effective immediately. CNinsure’s F-1 filed on October 10, 2007 indicated that Hermann Leung was a director of CISG Holdings Ltd. along with Wolansky. CISG Holdings Ltd. was the entity that sat one level below the Cayman holding company that went public. We do not know the length of Leung’s tenure as a board member.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: https://www.sec.gov/Archives/edgar/data/1413855/000119312507216115/dex47.htm

Cathay’s website provides Leung’s background, stating that he supervised the firm’s investments in China:

Source: https://www.cathay-capital.com/team

An article in the South China Morning Post stated that in 2009, the Securities and Exchange Commission in Hong Kong sought to ban him from being a director for up to 15 years, mentioning “alleged misconduct and management” on the board of a public company.

Source: https://www.scmp.com/article/692763/sfc-seeks-banning-ex-warderly-directors

The SFC’s allegations centered on shareholders being kept “in the dark” as the company began to experience financial distress, and eventually stock suspension:

Source: https://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=09PR131

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

In particular, the SFC alleged that Leung and a third party, as the company was failing, lent the company money at an interest rate of 5% per month, or 60% per year, “for which no written agreement had been entered into”:

Source: https://www.sfc.hk/web/doc/EN/general/general/press_release/09/09pr131_summary.pdf

In 2011, the SFC announced that it had disqualified Leung “for two years from being a director or being involved in the management of any listed company in Hong Kong.” Although this was less than the 15- year ban it had originally sought, SFC statements implied that the ban was unprecedented: “This is the first time an alternate non-executive director is disqualified for this type of misconduct.” We paste two other paragraphs from the same SFC release:

Source: https://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=11PR20

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Fanhua’s recent results – both revenue and earnings – are low quality and have high risk of being a mirage. Receivables have spiked while revenues have declined. The growth in receivables is driven by sharp growth in “other receivables,” comprised mostly of a “loan to [a] third party.” We have discovered that this “third party” is actually a related party which is not disclosed as one. This troubles us as revenue growth driven by transactions with undisclosed related parties was a hallmark of companies that failed during the offshore reverse-merger wave earlier this decade.

We begin by examining the company’s recent revenue trajectory by quarter and comparing it receivables. Key observations:

1. Receivables began to spike in Q1 2017 and have continued to scale in subsequent quarters. The increase is sharp: a recent high of 1,638mm RMB in Q3 2017 (423% increase from Q1 2016), and 1,526mm RMB as of Q2 2018 (390% increase from Q1 2016).

RMB mm 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 Life insurance revenue 160 205 263 NA 613 590 731 491 673 808 Total revenue 908 1,066 1,192 1,534 1,334 1,013 1,077 690 843 972

Accounts receivable 287 369 441 502 669 492 770 520 587 873 Other receivables 100 82 83 63 171 513 868 608 635 653 Total receivables 387 451 524 565 840 1,005 1,638 1,127 1,222 1,526 Source: Company filings and press releases. Q4 2016 reclassified revenue figures are not available and we were unable to deduce them from disclosed data.

Receivables continued to spike in 2017 even as total revenue declined, and have remained elevated – a red flag in assessing the quality and accuracy of the company’s reported revenue. We note the particularly sharp and above-trend increase in receivables in Q3 2017. Q3 is especially relevant, as that quarter marked an acceleration in life insurance revenue specifically and was the catalyst for FANH’s stock coming back to life after six years of being roughly flat. We also note the re-acceleration in receivables in the current quarter announced on August 20, 2018:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Company filings and press releases

The discrepancy between total life insurance revenue (vs. total revenue) and receivables is especially stark over the last four quarters. We find this troubling, particularly in the current quarter. Total revenues are down 4% year over year, yet receivables increased 52%. We suspect that some investors may focus on the 37% year over year growth in life insurance that the company just reported on August 20th for Q2 2018, yet the spike in receivables causes us to question how real and sustainable this “growth” is.

Source: Company filings and press releases

Receivables are a critical area to analyze, as certain US-listed Chinese companies that were exposed as engaging in accounting or other fraud exhibited red flags in their receivables profile. Related party fraud

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) was typically the mechanism employed: companies would recognize revenue with entities that they owned or controlled, accompanied by a rise in receivables as the revenue was fake and not collectible. Their financials were also characterized by discrepancies between earnings and cash flows, indicating that earnings were an accounting fiction.

We examined Fanhua’s filings to assess the risk of a similar scenario, and began by analyzing the composition of their receivables:

Source: Company’s 2017 20F filing

“Loans to third party” comprise the vast majority of other receivables. Footnotes for the “other receivables” section name the “third party” as Shenzhen Chuangjia Investment Partnership Ltd., with the equity of its operating subsidiary serving as collateral.

Source: Company’s 2017 20F filing

We retrieved SAIC filings for Shenzhen Chuangjia and traced its ultimate beneficial ownership, through multiple layers of intermediate entities, to an individual named Yu Hai Feng:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Yu Hai Feng Yang Yuan Feng

Renshou Puyi Enterprise Yu Hai Feng Management Center Limited

Sichuan Jiake Technology Co. Yu Hai Feng Limited

Renshou Xinrui Enterprise Management Center Yu Hai Feng Limited Partnership

Shenzhen Chuangjia

Investment Partnership Limited Source: China SAIC filings

The contact information listed for Yu Hai Feng in the filings contains an email address “@puyiwm.com.”

We visited www.puyiwm.com, which is a wealth management business. The company profile section states that the main operating entity for Puyi is Fanhua Puyi Fund Sales Ltd:

“The main operating entities of Puyi Wealth Products include:”

“Fanhua Puyi Fund Sales Co Ltd.”

Source: Puyi Wealth website, http://www.puyiwm.com/list-0a5a47d396e14ee2aedd952cec4b1804.html

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

This is troubling, as Fanhua Puyi Fund Sales Co. is shown at the very bottom of Fanhua’s corporate structure chart as an entity in which they own 15.4%, which makes it a related party, and not a “third party” as the receivables disclosure in their 20F states:

Source: Company filings

This indicates that the loan to a “third party,” which drove the escalation in Fanhua’s receivables over the past year, even as total revenue has plummeted, is driven by loans to an entity in which Fanhua reports 15.4% ownership, which makes it a related party transaction.

The question then becomes, is the ownership for Fanhua Puyi 15.4% as reported in the filing, or is it a fully or majority-owned or controlled party of Fanhua? Fanhua’s 20F for 2011 (when it was still known as CNinsure) indicated that it owned 57% of Fanhua Puyi Asset Management Co. Ltd., which appears to be almost certainly affiliated with Fanhua Puyi Fund Sales Co.:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Company filings

We have not uncovered dispositive proof that Fanhua owns more than 15% of Fanhua Puyi Fund Sales Co., and nor do we find it particularly necessary to do so. We have already established that they own 15% and that it is a related party, and that in a prior filing they disclosed 57% ownership of what appears to be an affiliated or predecessor entity. Given the maze of entities in Fanhua’s business structure, it would be easy for them to bury beneficial ownership in a myriad of ways, if they chose to do so.

In addition to Shenzhen Chuangjia Investment Partnership, we note another related party that we find to be suspicious. Fanhua’s most recent filing discloses a 21% stake in an entity called Sincere Fame, located in the British Virgin Islands. Unlike Shenzhen Chuangjia, Sincere Fame is disclosed as a related party in the filings. However, the nature and activities of the entity are opaque. On June 25, 2018, Fanhua filed an amendment to its form 20F filed on April 30, with unaudited financial statements for Sincere Fame.

Fanhua’s filings indicate that it granted a $50mm revolving loan facility to Sincere Fame in 2011, and that the facility has been renewed. The purpose of this facility is not disclosed [highlight added]:

We agreed to grant a revolving loan with a maximum amount of US$50.0 million (equivalent to RMB318.0 million as per the agreement) to Sincere Fame, and its subsidiaries, pursuant to a facility letter, or the Facility entered in October 2011. The facility is valid for two years and was renewed for another two years in October 2013 and October 2015. On January 1, 2012, we and Sincere Fame further entered into a supplemental loan agreement, which established the legal rights to offset the interests and amounts receivable and payable between us and Sincere Fame, and all subsidiaries of us and Sincere Fame. These amounts are unsecured, bear interest at 7.3% and are repayable on demand. As of December 31, 2016 and 2017, the amount due from Sincere Fame and its subsidiaries represented nil in principal receivable, and RMB32.5 million and nil interest receivable, respectively. The interest receivable is non-interest bearing.

Source: Company filings

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

The filing implies that the revolver is currently undrawn. The last filing in which a loan balance was indicated was for 2014, which disclosed a loan balance of $29mm at year end. However, we find the language in the filing to be odd, as it references a “supplemental loan agreement which established the legal rights to offset the interests and amounts receivable and payable between us and Sincere Fame….” We also find it odd that the filing doesn’t use typical language indicating the revolver is undrawn, and instead says that “the amounts due from Sincere Fame and its subsidiaries represented nil in principal receivable.” We were unable to locate the loan agreement as an exhibit to the company’s 2012 filings package, the year in which it was entered into, which we find unusual given the inclusion of other arcane agreements of a similar nature in the agreements filed.

Given our inability to locate the supplemental loan agreement, the use of odd language around offsets between Fanhua and Sincere Fame, and the atypical description of amounts due, we are concerned that Sincere Fame may remain a conduit for flow of cash to a BVI related party, especially given the lack of any explanation. Our investigation is ongoing, and we have not yet established whether transfers to Sincere Fame are recycled as related party “revenue” back to Fanhua, or whether this represents insider self-dealing of the type we have documented. Nonetheless, the mere existence of a $50mm loan facility to a BVI related party represents a significant red flag.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

We also note sharp discrepancies between operating income, earnings, and operating cash flows, which further cause us to doubt Fanhua’s reported margins and earnings. These discrepancies have accelerated in the most recent quarter. Divergences of this magnitude typically appear in the late stages of a situation, indicating difficulties in keeping reported results going, based on our experience.

In addition to analyzing the relationship between revenues, receivables, and related parties, we examine discrepancies between operating income, earnings, and cash flow. Another characteristic feature of the companies that failed during the reverse merger wave was high margins and earnings without operating cash flows, indicating that earnings were merely accounting accruals or vapor enabled by a rise in receivables or other asset accounts.

We focus on the last four quarters to keep it simple. The level of operating cash flow generated is paltry. The discrepancy between operating cash flow and operating income and earnings is stark. In each of the last four periods, OCF has been a fraction of earnings. In Q3 2017, OCF was particularly negative, which we find notable given the spike in reported life insurance revenues and earnings that quarter – results which kicked off a 4x rise in the stock over the next few months. OCF is also a fraction of operating income. The discrepancy has accelerated in the current quarter. The company just reported an acceleration in margins and operating income and earnings, yet operating cash flow has plummeted to negative – a significant red flag.

RMB mm 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 Total revenue 1,334 1,013 1,077 690 843 972 Operating income 55 71 83 62 90 128 % 4.1% 7.0% 7.7% 9.0% 10.7% 13.2% Net income 70 140 112 127 130 172 % 5% 14% 10% 18% 15% 18% Operating cash flow 9 109 (26) 60 31 (4) As % of revenue 0.7% 10.7% -2.4% 8.7% 3.6% -0.4% As % of operating income 16.5% 152.9% -30.9% 96.3% 33.9% -3.1% As % of net income 13.0% 77.6% -22.9% 47.2% 23.5% -2.3% Source: Company filings and press releases

The lack of cash flow conversion is visible graphically:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Source: Company filings and cash flows

In conclusion, our analysis of Fanhua’s spike in receivables and the lack of cash flow relative to earnings, and the fact that receivables have risen due to related-party transactions, causes us grave concern as to whether Fanhua’s reported revenues and earnings are accurate.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

We believe that investor enthusiasm about Fanhua’s “new” business model is misguided.

The main reason that Fanhua’s stock has sparked back to life is because of enthusiasm about a transition in mid to late 2017 from distributing low margin, commodity auto and property and casualty insurance to re-selling higher margin life insurance.

After announcing this shift, the company quickly reported a spike in life insurance commissions in Q3 2017, validating the pivot in investor’s minds. On the heels of a commensurate resumption of sell-side coverage endorsing this story, a perfect storm led investors to bid up stock. We quote a sell-side initiation report from late 2017:

We believe that the “strategic shift” from re-selling P&C insurance to life insurance is merely a cynical attempt to spin the abrupt loss of its largest P&C customer, PICC, in March 2017, as detailed in a previous section of this report.

PICC Property and Casualty Company was Fanhua’s largest customer in 2014, 2015, and 2016, representing 21%, 24%, and 27% of revenue respectively. In 2016, reselling P&C/auto insurance was Fanhua’s primary business, representing 76% of total agency revenue. PICC alone represented 45% of total P&C revenues.

PICC’s abrupt termination of business with Fanhua, due to its management being investigated by the government, crushed revenue in Fanhua’s largest division. This left the company with no other option except life insurance. PICC exited on March 1, 2017, and the impact is evident in Fanhua’s growth starting that quarter. The decline in P&C revenues is visible in Q1 2017, followed by a more dramatic decline in Q2 and into the remainder of the year as the segment collapsed:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Loss of PICC in Q1 (Mar 1 2017) wiped out P&C division

Source: Company flings and press releases As P&C revenue collapsed and life insurance comprised a larger percentage of a smaller base, the company began to spin the change as a proactive business model transition from low margin P&C business to betting the company on life insurance:

Source: Fanhua press release Aug 21, 2017, http://ir.fanhuaholdings.com/static-files/7550dd7e-71c7-46d0-957b- e437ddbdc7f0

On an earnings call, the company continued to represent the decline in P&C business as a strategic decision:

Source: Company earnings call transcript, Aug 22, 2017

We believe investors enthusiastic about the business model transition may be unaware that this “shift” is merely the latest in a long history of abrupt changes in the company’s direction. Moreover, the recent “transition” into life insurance specifically is anything but new, as the company has made numerous announcements going back 10 years about scaling its life insurance business, only to see their plans sputter. We detail the history of some of these announcements, to allow investors to gauge the credibility and duration of the latest story.

From 2007 to 2010, the company announced various acquisitions to enter into and scale its life insurance business. We quote representative press releases by date:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

12/17/07: “…as part of its efforts to expand into the distribution of life insurance products”

1/4/2008: “The acquisition sits squarely within our strategy of expanding nation-wide distribution network and developing life business.”

8/26/2008: “CNinsure is dedicated to improving its business structure with more focus on life insurance business […] Though property and casualty insurance business remained it's the biggest contributor in terms of revenues, life insurance business was increasingly gaining share…” (note: grammatical errors are from the original release)

9/18/2008: “'The acquisition of Datong will expedite the expansion of our life insurance distribution network and contribute significantly to the achievement of our life insurance revenue targets. What has attracted us most is Datong's management team, particularly their extensive experience in life insurance distribution and their broad business relationships in the life insurance sector.”

7/7/2009: In the middle of this flurry of announcements toward a life-insurance model, the company abruptly announced a new direction, saying that it “in lieu of being an insurance product distributor” it would now become a “consumer financial services” play focused on mortgage loans, mutual funds, and securities. The stock rose 50% in weeks on this announcement.

8/23/2010: However, within a year the company was back to distributing life insurance with no mention of being a broader consumer financials company: "We are thrilled to see that the strong growth momentum in our life insurance business continued into the second quarter, with life insurance growing over 138% year-over-year and accounting for 36.1% of our total net revenues…”

11/21/2011: The company announced another bizarre shift. “As we implement these strategic moves, we may experience a slowdown in growth during the coming two to three years, but we are confident that after these adjustments, CNinsure will have been transformed into a brand-powered and high-tech company that provides high value-added products to high-end customers….”

5/20/2013: The company once again de-emphasized insurance entirely and indicated it would now move into e-commerce and “comprehensive financial products”: “The financial results for the first quarter of 2013 also reflect a key decision made by management during the Company's strategic transformation. In view of the continuing increases in the commission costs of our P&C business and the growth slowdown of our life insurance business, we have decided to focus resources on developing our e- commerce business and strengthening our ability to offer comprehensive financial products and services which we believe will become our new growth engines.”

8/20/2013: A few months later, however, the focus on life insurance was back again. This release is especially important for investors to note, as it indicated a focus on “protection products” as traditional life insurance hit the wall. This is identical to the narrative the company has started promoting in recent months. As fast-return annuity products have been banned by the CIRC, the company is now emphasizing “protection products” as its growth driver. We believe the current focus on protection products is as likely to be as short-lived as the last one.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) first year life insurance premiums […] Despite the negative impact on life insurance business volume in the near-term, we believe this move is conducive to enhancing the long-term sustainability of our life insurance business….”

3/2/2015: The company indicated revised strategic priorities yet again, with internet finance being one of three core areas of focus: “We will resume our M&A strategy. Our M&A targets may include leading wealth management companies that have engaged in internet finance to broaden our product line, or companies that have innovative business models or leading internet finance technologies….”

11/6/2016: The company announced it was changing its name from CNinsure to Fanhua, as it was now – for the third time – shifting its direction back toward diversified financial services versus mere insurance re-sale: “After the name change, the Company also intends to change its ticker symbol from "CISG" to "FANH". These changes are intended to reflect the Company's current business direction as it is committed to becoming a leading diversified financial services provider, and to expanding its business scope beyond insurance distribution and services to offer comprehensive financial products and services to its clients.”

In spite of 10 years of announcements and hype about becoming a life insurance company, life insurance revenue in 2016 was only $143mm – a mere 21% of total revenues.

We note that life insurance revenue did grow in importance in 2017, but merely because their P&C business collapsed, and because of one-time, short-lived drivers in the life insurance market in China. We address those drivers and their sustainability in the next section.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

The recent operating results and business model change that led to a re-rating and resumption of sell- side coverage are likely to be fleeting and disappoint investors

As discussed, Fanhua’s P&C business has largely disappeared with the exit of PICC as their largest customer. At the same time, life insurance revenue has increased in aggregate and as a percentage of the total, leading investors to bid up the stock as a life-insurance growth story. Life insurance comprised 18% of quarterly revenues at the start of 2016, but comprised 83% of revenues as of Q2 2018. P&C comprised 59% and 9% of the same periods, respectively. The sharp reversal in segment mix is visible below:

Total Fanhua revenue RMB mm Q1 16 Q2 16 Q3 16 Q4 16 Q1 17 Q2 17 Q3 17 Q4 17 Q1 18 Q2 18 Life insurance 160 205 263 362 613 590 731 491 673 808 P&C 538 780 844 857 656 350 274 102 92 92 Total agency 698 985 1,107 1,219 1,269 940 1,005 593 765 900 Other 210 81 85 315 198 73 72 98 78 72 Total revenues 908 1,066 1,192 1,534 1,467 1,013 1,077 691 843 972 Revenue by segment Life insurance 18% 19% 22% 24% 42% 58% 68% 71% 80% 83% P&C 59% 73% 71% 56% 45% 35% 25% 15% 11% 9% Other 23% 8% 7% 21% 13% 7% 7% 14% 9% 7% Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Source: Company filings and press releases

Total revenue by segment (RMB mm) 1,800 1,600 1,400 1,200 1,000 800 600 400 200 - Q1 16 Q2 16 Q3 16 Q4 16 Q1 17 Q2 17 Q3 17 Q4 17 Q1 18 Q2 18

Life insurance P&C Other

Source: Company filings and press releases

Despite the growth in life insurance revenue, the decline in overall revenues has been dramatic as the company has failed to backfill lost P&C business. We go back by quarter to 2015 to indicate the company’s broader trajectory:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Total quarterly revenues (RMB mm) 1,400

1,200

1,000

800

600

400

200 NA* 0 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18

Source: Company filings, using reclassified figures from the most recent 20F. *Q4 2016 reclassified figures are not available and we were unable to deduce them from disclosed data.

The company’s growth rate collapsed in Q2 2017, when PICC terminated its business. The stock was at ~$8.50 at that time. We find it remarkable that the stock’s spike from ~$8.50 to a recent high of $37 -a 435% rise – occurred over the same timeframe that year-over-year growth accelerated its decline:

Total Revenues - Year Over Year Growth Rate 80% 66% 57% 59% 60% 47% 36% 40% 32% 32% 24% 20% NA* -5% -10% NA* -4% 0% 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 -20%

-40% -37% -60%

Source: Company filings, using reclassified figures from the most recent 20F. Q4 2016 reclassified figures are not available and we were unable to deduce them from disclosed data.

Investors have enthusiastically – and in our view, naively – embraced the effective disappearance of the P&C business as intentional and strategic, believing that Fanhua has a large and rapidly growing number of sales agents to drive growth in life insurance. The acceleration in life insurance revenue from Q1 to

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Q3 2017 is viewed as evidence, particularly the spike in Q3 2017, which accelerated the parabolic move in the stock:

Source: Company filings and press releases

Lest there be any doubt, management has promoted the new shift into life insurance as the future of the company [highlight added]:

Source: Company press release 5/23/17

In more recent press release, dated 5/21/18, the CEO stated that “[T]he fundamentals of our life insurance segment remain solid, as evidenced by the strong growth momentum in both registered sales agents and performing sales…”

A critical question for investors is therefore the sustainability of Fanhua’s newly found growth in reselling life insurance. We have already addressed the size and growth of Fanhua’s sales agent channel, as well as the company’s failed 10 year history of previous “pivots” into life insurance. Is this time different?

It is our belief, contrary to those extrapolating growth in life insurance revenue in late 2017, that the recent growth is fleeting and driven by one-time factors. In recent years, a wild west dynamic developed in Chinese life insurance, where insurers offered “fast-return” products that guaranteed high rates of return and return of principal in a rapid time-frame. These products – which were critical to Fanhua’s growth and the stock move from $8 to $30 in months – were turbocharged investment products vs. traditional life insurance, as life insurance has historically been perceived as a banking/savings product

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) in China. These products became a growth driver for life insurance players in China in general. We believe that Fanhua, seeing the deterioration in its P&C/auto business and the rush into fast return products, decided to pivot last year into this trend.

However, just as the company “shifted” its business model toward life insurance, regulators acted to eliminate the sale of high-risk, fast-return products. Fast return policies were used by life insurers as a source of funds for M&A and growth. Regulators became alarmed at obvious systemic risks and abuses, and began to crack down aggressively on insurers. As evidence of the sudden change in regulatory posture, the government seized one of the largest insurers, Anbang Insurance Group, in February 2018 and sentenced its former chairman to 18 years in prison. We quote from a recent article:

“The Chinese insurance regulator's seizure of Anbang Insurance Group Co. Ltd. is a further example of the government's effort to crack down on corruption and rein in its insurance sector….Anbang's former chairman, Wu Xiaohui, has been charged with alleged "economic crimes," with prosecutors saying he is being accused of fundraising fraud and abusing his position.

Anbang has for several years used cash generated from its insurance business to fund expansion in China and overseas, vacuuming up assets that included Dutch and Belgian financial institutions, stakes in Chinese banks and New York's Waldorf Astoria hotel.

But there had been signs in 2017 that Chinese officials were keen to slow the acquisition train at both Anbang and other previously active Chinese companies, and the Feb. 23 seizure of Anbang is perhaps the most dramatic step in that direction so far. Many of the deals struck by Anbang and others were funded by premium income, much of which came from high-risk financial products sold to the public that are now largely prohibited.”

Source: https://www.snl.com/interactivex/article.aspx?KPLT=7&id=43648930c

Critically for Fanhua, as part of a broader crackdown on corruption and abuses in the sale of life insurance products, the Chinese Insurance Regulatory Commission (CIRC) Issued Circular 134, which banned the sale of high-risk life insurance products effective Oct 1, 2017. We noted in a previous section that Fanhua’s largest customer, Huaxia, grew dependent upon the sale of these products.

The timing of this ban is vital in understanding Fanhua’s life insurance growth last year, especially in Q3 2017. Note from the chart above that Fanhua’s life insurance sales spiked in Q3. Coming just a few weeks after a major US bank initiated coverage of Fanhua, the Q3 spike precipitated a sharp move in Fanhua’s stock. The enthusiasm was apparent in Fanhua’s Q3 press release [highlights added]:

Source: Fanhua press release 11/20/2017

The press release was silent on the driver of this sudden spike, but the earnings call was more revealing:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

“Now let's look at the performance of each of our major business segments. Firstly, life insurance business. In May 2017, CIRC Issue No. 134 notice, prohibiting the sales of universal life insurance or unit linked insurance products as rider policies and the payment of survival benefits on endowment and annuity insurance products in the first 5 years, while the annual payable amount is capped at no more than 20% of the contributed premiums. This regulation, which came into effect on October 1, 2017, was one of the major catalysts behind the explosive growth in the sales of our annuity life insurance products in September, during which the first year premium on life insurance business reached RMB 570 million, up 380% from a year ago, which is the highest single month new policy sales ever recorded by the company.”

Source: Fanhua Q3 earnings call, 11/20/2017

In other words, the sudden acceleration in life insurance revenue in Q3 was driven by consumers rushing to purchase fast-return policies and lock in guaranteed rates of return prior to the policies being banned on October 1, 2017.

Since the ban took effect, we see the effect in Fanhua’s life insurance growth rate:

CIRC ban Oct 1, 2017

Source: Company filings and press releases

The Q4 earnings release, the first results following the CIRC ban, indicated the impact and kicked off a sideways trend in the stock:

"As we enter 2018, new premiums were down across the life insurance market during the Jumpstart sales season, due to the drastic decline in the sales of annuity and universal products which used to be the major contributors behind the rapid growth in life insurance premiums in the past two years. Sales in these products have decreased mainly as a result of high bond yields and CIRC-guided product changes towards higher protection features in new product design. Despite that, we believe that the structural growth of the life insurance market will continue as there is still significant room for more

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) growth in the sales of protection-oriented life insurance products. As for Fanhua, protection-oriented insurance products have always been and will continue to be our focus. “

Source: Fanhua press release 3/12/2018

The company’s press release, on 8/20/2018 for Q2 2018, indicated that new life insurance sales are expected to decline year over year in the following quarter: “Looking ahead to the second half of 2018, in light of the extremely high base in the third quarter of 2017 primarily owing to the swell of fast- return annuity and participating endowment products following the implementation of Circular No. 134, we expect to see a slight year-over-year decrease in new life insurance premiums in the third quarter of 2018.”

Given the ban on fast return products, Fanhua is now attempting to sell investors a second business model pivot in under a year. As high-risk annuities underpinning life insurance sales have evaporated, the company is positioning investors toward a second pivot into a subset of life insurance, as alluded to in the Q4 2018 release: “Despite that, we believe that the structural growth of the life insurance market will continue as there is still significant room for more growth in the sales of protection-oriented life insurance products. As for Fanhua, protection-oriented insurance products have always been and will continue to be our focus. “

We note that the company already attempted a transition toward protection products, as announced below in 2013, with deafening silence in subsequent releases until a few months ago:

“Amid the industry trend towards the protection business, we adjusted our life insurance product strategy during the second quarter of 2013 by shifting our sales focus from participating policies to traditional protection policies […] This shift was one of the major reasons for the drastic decline of our first year life insurance premiums […] Despite the negative impact on life insurance business volume in the near-term, we believe this move is conducive to enhancing the long-term sustainability of our life insurance business….”

Source: Company press release 8/20/2013

Regarding the potential of “protection-oriented” products, a May 2018 article from the Financial Times titled “China’s life insurers face tough time as premiums keep falling” indicated that protection products “are difficult to sell in a culture where savers expect a guaranteed return.” The piece provided further color on current industry dynamics, stating that regulators are targeting “short-term, high-yielding investment products that contained only a nominal element of risk protection,” and that “industry observers thought the worst was over, but the decline accelerated this year, with premiums dropping 8 per cent in the first quarter from last year’s already-diminished base.”

Source: Financial Times May 20, 2018 https://www.ft.com/content/892aea0c-5a57-11e8-bdb7-f6677d2e1ce8

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Given FANH’s history and current dynamics, our target price is $5.49 per ADS, a 79% decline from its last close. We believe shares may be worth as low as $0.

We believe that valuing Fanhua is not a complicated exercise. When a company has a history of alleged fraud, and is engaging in behavior of the type that we have documented, its reported revenues, margins, and earnings are inherently suspect and lack credibility, for which the market applies a punishing multiple.

Overall revenues are down year over year. Receivables have spiked. Reported operating income and earnings aren’t matched by cash flow conversion. Even recent reported earnings growth is driven by cuts in SG&A, a strange anomaly for a company that claims to be adding thousands of new sales agents per month. Until last year, operating income was minimal for years and the main source of earnings was returns on its cash balance, yet now that cash balance stands to be drained by $247mm in a transaction with the founder, and likely by far more to fund the company’s new “incentive plan.”

As investors begin to grasp that the bull case for the stock is based on misguided assumptions, we believe the stock will revert to the price and valuation range it traded in during its out-of-favor period between Q4 2011 and Q3 2017. In Q4 2011, remaining investors fled and the stock traded in a tight range generally between $5 to $9 per ADS, for the next six years. The market remained skeptical until Q3 2017, at which point the stock spiked.

Source: Bloomberg

We note the company’s current trading multiples relative to their average during this period, and the sharp multiple escalation following the stock’s ascent in late 2017:

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Out-of-favor period 8/24/2018 EV/LTM Revenue 0.2 2.4 EV/LTM EBITDA 3.1 21.3 EV/LTM EBIT 4.7 24.0 P/E, trailing 16.5 21.5 P/BV 0.8 2.8 Source: Company filings and Seligman analysis

We provide three methods for valuing the stock.

One: Assume that FANH’s stock price reverts back to its range between Q4 2011 and Q3 2017.

The length and persistence of the company’s historical trading range establishes a credible price and valuation benchmark for where FANH is likely to revert, as the market prices in the same level of skepticism it exhibited over that period. Given the company’s history of alleged fraud and the events of 2010/2011, the reaction could be more even severe the second time.

This method yields a target price of $7.25 per ADS, the average of its daily closing prices over that period.

Two: Apply an asset-based valuation methodology, anchored to the company’s main asset account, which is cash.

When a company’s revenues, margins, and earnings are viewed as suspect, investors may gravitate to the company’s reported cash balance as the only “safe” asset. This is especially likely in FANH’s case, as cash comprises the majority of its total assets ($422mm in cash and short term investments as of 6/30/18, out of $780mm in total assets, or 54%).We note that FANH’s market cap traded below the value of its reported cash balance for long stretches of the last seven years, indicating the depth of investor skepticism. It is unusual to find companies that trade with a negative enterprise value for so long.

During this time, FANH’s market cap averaged 97% of the company’s cash balance.

In addition to applying this multiple to the current cash balance, we adjust cash for two transactions: i) the recent purchase of 8.5mm ADS’s from the founder at $29/share, for $247mm; and ii) the $177mm of net outflows that we estimate is likely from the company’s “funding” of its recently announced “incentive plan.” This yields target prices of $6.30, $2.61, and $0 per ADS. Adjusting cash for $177mm of outflows actually results in a slightly negative cash balance, indicating the magnitude of outflows contemplated, for which we just assume a $0 share price scenario.

We presume management would leave enough cash to keep the shell viable as a public company, but believe that scenario would wipe out any meaningful equity value. Given the company’s i) complex and opaque business structure, ii) its history of related-party and fictitious transactions, and iii) the risks inherent to an offshore VIE structure where shareholder claims to the assets and earnings of the company’s operating entities in China are dependent upon contractual agreements, the risks and enforceability of which are a subject of discussion among experts, we believe it is entirely plausible that Fanhua’s shares have zero equity value.36

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

Using current cash balance Cash and short term investments, 6/30/2018 $422 Implied equity value @ 97% of cash $409 ADR's outstanding 65 Implied share price $6.30

Less: cash to founder Cash and short term investments, 6/30/2018 $422 Less: cach outflow to founder $247 Remaining cash $175 Implied equity value @ 97% of cash $170 ADR's outstanding 65 Implied share price $2.61

Less: cash to fund "incentive plan" Cash and short term investments, 6/30/2018 $422 Less: cach outflow to founder $247 Less: incentive plan outflows $177 Remaining cash -$2 Implied equity value @ 97% of cash -$2 ADR's outstanding 65 Implied share price -$0.03 Source: Company filings, press releases, and Seligman estimates and analysis

As a second asset-based valuation methodology, we calculate a target price using price to book value. We adjust the company’s common equity for cash outflows to the founder and to the new incentive plan, yielding target prices of $4.49 and $2.28 per ADS.

Book value/share Total assets $780 - Total liabilities $157 = Total equity $623 - Minority interest $16 = Common equity $607 - Cash outflow to founder $247 = Common equity after cash to founder $360 - Cash to fund "incentive plan" $177 = Adjusted common equity $183

ADS's outstanding 65 Current book value/ADS $9.34 Book value/ADS less cash to founer $5.54 Book value/ADS less cash to incentive plan $2.82

Average P/BV during penalty box period .81x Implied ADS price, less cash to founer $4.49 Implied ADS price, less cash to incentive plan $2.28 Source: Company filings, press release, and Seligman estimates and analysis

Three: Apply a historical revenue multiple to reported revenues

We do not believe the company’s EBIT, EBITDA, or earnings are credible. We also note that for many years, until 2017, operating income was negligible and the company’s main source of earnings was the investment return on its cash balance. As the cash balance dwindles following the transaction with its founder and the funding for its new “incentive plan,” the prospect of future investment earnings essentially disappears. In the absence of credible operating income or earnings, we are left with revenue.

First, we apply a straight revenue multiple. There is only one sell-side firm covering the stock, CICC in China, and their current revenue estimate for 2018 is $497mm. This compares to an LTM figure of $524mm. We use $524mm to be generous, yielding a target price of $8.35.

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

As of 6/30/18 LTM revenue $524 Average EV/revenue 0.2 Implied EV $105 + Cash and short term invesments $422 + Minority interest $16 Implied equity value $543 Price/ADS $8.35 Source: Company filings, press release, and Seligman estimates and analysis

Second, we again adjust the cash balance for cash outflows to the founder and incentive plan, resulting in target prices of $4.55 and $1.83.

Third, we assume that current revenues are inflated, as they have been accompanied by a sharp rise in “other receivables” to a related party. Receivables have grown from $56mm to $231mm over the past two years, or $175mm. We use a crude methodology and reduce our $524mm revenue estimate by the amount of the receivables increase, resulting in $349mm of adjusted “real” revenue. This yields a target price of $7.81, without applying any haircut to the current cash balance.

The average target price implied by the methodologies we use is $5.49/share, a 79% discount to the closing price as of August 24, 2018.

Methodology Price Stock reverts to avg price between Q4 2011 and Q3 2017 $7.25 Asset-based valuation Multiple of cash $2.97 Price to book $3.39 Revenue multiple Using current revenue $8.35 Adjusted for cash outflows $3.19 Adjusted for A/R spike $7.81 Average target price $5.49 Source: Company filings, press release, and Seligman estimates and analysis. Please note that prices shown under multiples of cash, price to book, and revenue multiple adjusted for cash outflows are each an average of two separate prices as discussed above.

The primary risks to our target price and thesis include the following:

• The company could use additional related-party transactions and/or low-quality receivables to construct revenue and earnings, leading to reported results that cause investors to remain enthusiastic about the stock.

• The company has somewhat concentrated ownership and could theoretically engage in stock manipulation using offshore or other entities. We have not documented any evidence in this report to indicate that they are currently doing so. However, we have noticed periods of trading behavior in the stock that cause us concern. We note odd and worrisome comments that management has made in the past about using offshore entities to trade stock:

“Next, in relation to employee equity holding company or Finestart Holdings Limited to our knowledge, it is an independent operating company and so as of which connecting the company to U.S. stock trading and providing our employees and sales agents with the U.S. and CISG stock

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

trading services. After all well-facilitated channel for America stock trading is difficult to find in China, in Mainland China. We believe this is an effective way to help our employees and sales agents to share a slice of cake while the company is growing well. In fact, Finestart Holdings Limited would collect a full amount of investment funds from each participants [sic], before it makes all the collective money into the American stock market.”37

• The company may have an investor base that doesn’t care about the types of fundamental issues that we have identified and may be valuation insensitive.

• Management could try to take the company private a second time.

1 Estimate from two prime brokers, as ADR’s don’t have a float of outstanding shares per se. “Short interest” for ADR’s is a term of art with no precise meaning. 2 J.P. Morgan Chase & Co. report, “Fanhua Inc. Agent of Opportunity – Initiate with OW”, Oct 10, 2017. Copyright 2018

3 Pieter Van Dongen, et al. v. CNinsure Inc., et al. 11-CV-07320. US District Court, Southern District of New York, p10. http://securities.stanford.edu/filings-documents/1047/CISG00_01/2012813_r01c_11CV07320.pdf 4 We define cash as cash and equivalents, such as short term investments. 5 Financial Times, “Foreign investors negotiate Chinese minefield,” Nov 29, 2011. https://www.ft.com/content/897e2c84-1a6d-11e1-ae4e-00144feabdc0

6 Per Bloomberg data, indicating that Fosun holds 15% of the outstanding shares of FFGRP GA and is the second largest holder, with the founder as the largest. 7 OLP Global report, as cited in Pieter Van Dongen, et al. v. CNinsure Inc., et al. 11-CV-07320. US District Court, Southern District of New York, p17. 8 Ibid, p.20 9 Ibid, p.20-21 10 Ibid, p.18-19 11 Transcript of “Business Update Call” by CNinsure on 12/3/2010 12 Ibid. 13 Company press release 12/6/2010. http://ir.fanhuaholdings.com/news-releases/news-release- details/statements-clarification-cninsure 14 OLP Global report, as cited in Pieter Van Dongen, et al. v. CNinsure Inc., et al. 11-CV-07320. US District Court, Southern District of New York, p.35-6. 15 Ibid, p.30 16 OLP Global report, as paraphrased in Pieter Van Dongen, et al. v. CNinsure Inc., et al. 11-CV-07320. US District Court, Southern District of New York, p.35.. 17 OLP Global report, as cited in Pieter Van Dongen, et al. v. CNinsure Inc., et al. 11-CV-07320. US District Court, Southern District of New York, p.35 18 Transcript of “Business Update Call” by CNinsure on 12/3/2010 19 OLP Global report, as cited in Pieter Van Dongen, et al. v. CNinsure Inc., et al. 11-CV-07320. US District Court, Southern District of New York, p.37 20 Ibid, p.37 21 Ibid, p.38 22 Ibid, p.38 23 Ibid, p.38-9 24 Ibid, p.39 25 Ibid, p.40 26 Ibid, p.40

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH)

27 Ibid, p.40-1 28 Ibid, p.41 29 Ibid, p.41 30 Ibid, p.43 31 Financial Times, “Foreign investors negotiate Chinese minefield,” Nov 29, 2011. https://www.ft.com/content/897e2c84-1a6d-11e1-ae4e-00144feabdc0 32 Asia Insurance Review, 4/6/17, http://www3.asiainsurancereview.com/News/View-NewsLetter- Article/id/38769/Type/eDaily/China-Life-insurance-agents-number-6-5-mln-at-2016-yearend 33 https://www.scmp.com/news/china/economy/article/2141462/chinese-tycoon-xiao-jianhua-missing-15- months-vanishing-hong-kong 34 Company press release, http://ir.fanhuaholdings.com/news-releases/news-release-details/cninsure-expand- new-share-issue-employees 35 Company press release 8/31/2011, http://ir.fanhuaholdings.com/news-releases/news-release-details/cninsure- announces-acquisition-two-insurance-agencies 36 Numerous articles online discuss the risks of Chinese VIE structures, such as https://rroyselaw.com/international-law/ecommerce/the-china-vie-structure-is-vulnerable-so-why-is-it-still-used/. 37 Transcript of “Business Update Call” by CNinsure on 12/3/2010