Talking Point

The fraud fighters

Muddy Waters is on a (profitable) mission to expose dodgy Chinese firms

Seeing the wood for the trees: Muddy Waters has accused Sino-Forest of fraud

Effectively a Ponzi scheme” is an accusation that is always going to get attention, especially in the post-Madoff era.
And so it turned out for short-seller Muddy Waters Research – its name inspired by the Chinese proverb that “muddy waters make it easy to catch fish” – with the publication of a report on Sino-Forest, a timber plantation company listed in Toronto. It alleged a fraud “stratospheric in size” at the forestry firm.
Sino-Forest reacted furiously, seeing it more as a case of the short-seller throwing as much mud as it could, and hoping that enough of it will stick.
None of the allegations against Sino-Forest have been proven and its shares continue to trade.
But its stock has now dropped by more than three quarters since Muddy Waters first went public with its accusations. The row is also igniting wider controversy about a large group of ‘reverse takeover’ Chinese stocks traded in North America, and whether they should be declared too risky for investors.
How did the Sino-Forest dispute start?
After Muddy Waters issued a research note citing the “granddaddy” of frauds.
The report has three major gripes: the process by which Sino-Forest sells its timber (via an “authorised intermediary” structure that it says is fictitious), the value of the forestry assets that Sino-Forest owns (overstated by $800 million in Yunnan province alone, says the report), and the scale of timber sales being reported (they exceed the permitted harvesting quota by a factor of six, says the short-seller).
Simply transporting all of this timber would have needed 50,000 trucks to travel the treacherous roads of mountainous Yunnan, Muddy Waters claims.
“Far beyond belief,” it scoffs.
But Sino-Forest was quick to fire back at its accuser for being “inaccurate, spurious and defamatory”.
“It is they who deliberately muddy the waters, not us”, warned company chairman Allen Chan, insisting that Muddy Waters has got its analysis completely wrong (much of its revenue results from the sale of standing timber, Sino-Forest says, so there is no cutting or transport involved).
Chan warned too that Muddy Waters – as a short-seller – had everything to gain by driving down the stock price with accusations of malpractice.
“It is the rest of us that lick our wounds, while they lick their lips,” he reminded investors.
Why is the spat getting media attention?
One reason is that John Paulson – $15 billion better off after betting against the US property sector in 2008 – is Sino-Forest’s largest shareholder. If the Muddy Water allegations are proved to be correct, he will be out-of-pocket hundreds of millions of dollars.
But there is also the bigger picture of the reverse takeover (RTO) world that has allowed many of the Chinese companies now accused of malpractice to list in North America in the first place.
The RTO process normally involves a public shell company buying a Chinese firm that is looking for funding. In reality, the purchased entity gains a controlling interest, most often through a placement on an over-the-counter board. The plan is then to move to an exchange listing and sell further rounds of equity to North American investors excited by the China growth story.
According to the US Public Company Accounting Oversight Board, 159 Chinese companies went public in the US via reverse takeovers from the start of 2007 through to the end of March last year. That was almost three times the number of Chinese firms that launched traditional IPOs in the US over the same period.
Why are the Chinese keen on RTOs?
It’s the least onerous way to raise money, as the financial disclosure requirements are much less taxing than for a full-blown IPO.
Reverse mergers overseas also look appealing for bosses facing a long wait for approval to IPO in Shanghai and Shenzhen, especially when it can be a struggle to source loans from banks in the meantime (the latest in a series of reserve ratio requirement hikes on Tuesday took another $58 billion out of the lending market).
And for the minority who might have less-than-honourable intentions, it is probably better to target foreign investors for the sting. At least, that’s the view of Muddy Waters founder, Carson Block. “If these guys were pulling the same thing in China, the punishment is a bullet to the head,” he told CNBC last week.
Hence some of poor publicity for the RTO sector at the moment, with the US Securities and Exchange Commission reporting that at least 24 Chinese firms had announced auditor resignations or trading halts in March and April alone.
Last week the SEC issued a bulletin warning investors that many companies will “fail or struggle to remain viable” following reverse takeovers.
One of its bullet-point recommendations: “Be Sceptical”.
So the short-sellers scent blood?
From late last year, the shorts have been steadily picking holes in a number of the China firms.
For example, in February Bronte Capital lauded the “superhuman” staff working the production line at an Anhui factory run by China Agritech, a fertiliser firm in which it had taken a short position.
But the compliment was a barbed one, in questioning how Agritech could be producing the 100,000 tonnes a year of fertiliser it claimed at a plant in Anhui province. Details on staff numbers implied no more than 40 on the production line, Bronte Capital estimated, which would mean each employee was filling, stitching and loading at least 17 bags of 40kg fertiliser a minute, for 8 hours a day, 300 days a year.
Shortly afterwards, Agritech’s auditor was fired after threatening to resign. The company failed to file accounts and was delisted from Nasdaq.
For China MediaExpress (which sells advertising on bus TV screens) the accusation was even more straightforward. “No one in China has ever heard of them,” Citron Research announced, after a search on Baidu and Google failed to find mention of the Nasdaq-listed company’s business.
Subsequently, its CFO and auditor also resigned. It too was delisted from Nasdaq.
So who is to blame for the current mess?
Companies seeking to mislead investors are clearly most at fault, although the investors themselves (some of them respected financial institutions) share some responsibility for failing to do proper due diligence.
The auditors are also coming in for flak, for signing off on the financial statements of those now on the warning list.
But audit firms complain of challenges in securing full disclosure, something recognised by the Public Company Accounting Oversight Board in the US, which has been pushing for more oversight.
So far, the Chinese authorities have blocked it from inspection audits on-site.
Even confirming a company’s cash balance at the bank can be a struggle, says Paul Gillis, visiting professor of accounting at Peking University’s Guanghua School of Management.
Gillis says bank officials in local branches can be persuaded to sign-off on fraudulent statements, so companies may not have the cash reserves that they claim.
Similar concerns were behind Deloitte’s departure as auditor at Longtop Financial (a software provider listed in New York) in May. Deloitte also dumped bus advertiser China MediaExpress for something similar two months earlier.
This Monday US regulators blocked new share issuance in two other stocks – China Intelligent Lighting and Electronics, and China Century Dragon Media – after it was revealed that they had both failed to disclose that their own auditors had quit after questioning the accuracy of financial statements.
But others insist that Chinese firms can be victims as well as villains in the reverse takeover process – often being misled by unscrupulous middlemen. Less than 20% of the Chinese businesses in over-the-counter placements actually make the transition to trading on a main board, one investor told Caixin this month. And that leaves them stuck in limbo, with no trade in their shares and little opportunity to raise further capital.
What next?
Back to the Sino-Forest spat: the company warned at its quarterly results on Tuesday that it will take its  new auditors PricewaterhouseCoopers up to three months to complete a full review. But it said it was confident that it would rebut Muddy Waters’ accusations.
Investors seemed unsure and the stock price continued to decline. Data Explorers, a provider of securities financing information, says that so much of Sino-Forest’s equity is now out on loan to short-sellers that “it would be hard to short more of the company”.
The Financial Times meanwhile reports that Sino-Forest’s US dollar bonds were trading this week at 55 cents on the dollar.
More significantly, there are signs that the reputational blowback from the RTO sector is hitting the broader market.
Bloomberg reported last week that a wider index of 50 Chinese stocks trading in Canada (where Sino-Forest is traded too) has performed nine times worse than the Shanghai Stock Exchange Composite Index in June.
This week the Wall Street Journal was also reporting that two China-based companies were forced to delay US dollar bond issues in Hong Kong, despite having no link to the reverse-takeover entities.
As the FT points out, it’s all proving very damaging to the China brand: “Buying a stock or bond with China or Sino in its name used to be a sure-fire route to riches, so strong was the demand for a piece of the world’s hottest emerging market. Now that trade has gone into reverse.”

“Effectively a Ponzi scheme” is an accusation that is always going to get attention, especially in the post-Madoff era.

And so it turned out for short-seller Muddy Waters Research – its name inspired by the Chinese proverb that “muddy waters make it easy to catch fish” – with the publication of a report on Sino-Forest, a timber plantation company listed in Toronto. It alleged a fraud “stratospheric in size” at the forestry firm.

Sino-Forest reacted furiously, seeing it more as a case of the short-seller throwing as much mud as it could, and hoping that enough of it will stick.

None of the allegations against Sino-Forest have been proven and its shares continue to trade.

But its stock has now dropped by more than three quarters since Muddy Waters first went public with its accusations. The row is also igniting wider controversy about a large group of ‘reverse takeover’ Chinese stocks traded in North America, and whether they should be declared too risky for investors.

How did the Sino-Forest dispute start?

After Muddy Waters issued a research note citing the “granddaddy” of frauds.

The report has three major gripes: the process by which Sino-Forest sells its timber (via an “authorised intermediary” structure that it says is fictitious), the value of the forestry assets that Sino-Forest owns (overstated by $800 million in Yunnan province alone, says the report), and the scale of timber sales being reported (they exceed the permitted harvesting quota by a factor of six, says the short-seller).

Simply transporting all of this timber would have needed 50,000 trucks to travel the treacherous roads of mountainous Yunnan, Muddy Waters claims.

“Far beyond belief,” it scoffs.

But Sino-Forest was quick to fire back at its accuser for being “inaccurate, spurious and defamatory”.

“It is they who deliberately muddy the waters, not us”, warned company chairman Allen Chan, insisting that Muddy Waters has got its analysis completely wrong (much of its revenue results from the sale of standing timber, Sino-Forest says, so there is no cutting or transport involved).

Chan warned too that Muddy Waters – as a short-seller – had everything to gain by driving down the stock price with accusations of malpractice.

“It is the rest of us that lick our wounds, while they lick their lips,” he reminded investors.

Why is the spat getting media attention?

One reason is that John Paulson – $15 billion better off after betting against the US property sector in 2008 – is Sino-Forest’s largest shareholder. If the Muddy Water allegations are proved to be correct, he will be out-of-pocket hundreds of millions of dollars.

But there is also the bigger picture of the reverse takeover (RTO) world that has allowed many of the Chinese companies now accused of malpractice to list in North America in the first place.

The RTO process normally involves a public shell company buying a Chinese firm that is looking for funding. In reality, the purchased entity gains a controlling interest, most often through a placement on an over-the-counter board. The plan is then to move to an exchange listing and sell further rounds of equity to North American investors excited by the China growth story.

According to the US Public Company Accounting Oversight Board, 159 Chinese companies went public in the US via reverse takeovers from the start of 2007 through to the end of March last year. That was almost three times the number of Chinese firms that launched traditional IPOs in the US over the same period.

Why are the Chinese keen on RTOs?

It’s the least onerous way to raise money, as the financial disclosure requirements are much less taxing than for a full-blown IPO.

Reverse mergers overseas also look appealing for bosses facing a long wait for approval to IPO in Shanghai and Shenzhen, especially when it can be a struggle to source loans from banks in the meantime (the latest in a series of reserve ratio requirement hikes on Tuesday took another $58 billion out of the lending market).

And for the minority who might have less-than-honourable intentions, it is probably better to target foreign investors for the sting. At least, that’s the view of Muddy Waters founder, Carson Block. “If these guys were pulling the same thing in China, the punishment is a bullet to the head,” he told CNBC last week.

Hence some of poor publicity for the RTO sector at the moment, with the US Securities and Exchange Commission reporting that at least 24 Chinese firms had announced auditor resignations or trading halts in March and April alone.

Last week the SEC issued a bulletin warning investors that many companies will “fail or struggle to remain viable” following reverse takeovers.

One of its bullet-point recommendations: “Be Sceptical”.

So the short-sellers scent blood?

From late last year, the shorts have been steadily picking holes in a number of the China firms.

For example, in February Bronte Capital lauded the “superhuman” staff working the production line at an Anhui factory run by China Agritech, a fertiliser firm in which it had taken a short position.

But the compliment was a barbed one, in questioning how Agritech could be producing the 100,000 tonnes a year of fertiliser it claimed at a plant in Anhui province. Details on staff numbers implied no more than 40 on the production line, Bronte Capital estimated, which would mean each employee was filling, stitching and loading at least 17 bags of 40kg fertiliser a minute, for 8 hours a day, 300 days a year.

Shortly afterwards, Agritech’s auditor was fired after threatening to resign. The company failed to file accounts and was delisted from Nasdaq.

For China MediaExpress (which sells advertising on bus TV screens) the accusation was even more straightforward. “No one in China has ever heard of them,” Citron Research announced, after a search on Baidu and Google failed to find mention of the Nasdaq-listed company’s business.

Subsequently, its CFO and auditor also resigned. It too was delisted from Nasdaq.

So who is to blame for the current mess?

Companies seeking to mislead investors are clearly most at fault, although the investors themselves (some of them respected financial institutions) share some responsibility for failing to do proper due diligence.

The auditors are also coming in for flak, for signing off on the financial statements of those now on the warning list.

But audit firms complain of challenges in securing full disclosure, something recognised by the Public Company Accounting Oversight Board in the US, which has been pushing for more oversight.

So far, the Chinese authorities have blocked it from inspection audits on-site.

Even confirming a company’s cash balance at the bank can be a struggle, says Paul Gillis, visiting professor of accounting at Peking University’s Guanghua School of Management.

Gillis says bank officials in local branches can be persuaded to sign-off on fraudulent statements, so companies may not have the cash reserves that they claim.

Similar concerns were behind Deloitte’s departure as auditor at Longtop Financial (a software provider listed in New York) in May. Deloitte also dumped bus advertiser China MediaExpress for something similar two months earlier.

This Monday US regulators blocked new share issuance in two other stocks – China Intelligent Lighting and Electronics, and China Century Dragon Media – after it was revealed that they had both failed to disclose that their own auditors had quit after questioning the accuracy of financial statements.

But others insist that Chinese firms can be victims as well as villains in the reverse takeover process – often being misled by unscrupulous middlemen. Less than 20% of the Chinese businesses in over-the-counter placements actually make the transition to trading on a main board, one investor told Caixin this month. And that leaves them stuck in limbo, with no trade in their shares and little opportunity to raise further capital.

What next?

Back to the Sino-Forest spat: the company warned at its quarterly results on Tuesday that it will take its new auditors PricewaterhouseCoopers up to three months to complete a full review. But it said it was confident that it would rebut Muddy Waters’ accusations.

Investors seemed unsure and the stock price continued to decline. Data Explorers, a provider of securities financing information, says that so much of Sino-Forest’s equity is now out on loan to short-sellers that “it would be hard to short more of the company”.

The Financial Times meanwhile reports that Sino-Forest’s US dollar bonds were trading this week at 55 cents on the dollar.

More significantly, there are signs that the reputational blowback from the RTO sector is hitting the broader market.

Bloomberg reported last week that a wider index of 50 Chinese stocks trading in Canada (where Sino-Forest is traded too) has performed nine times worse than the Shanghai Stock Exchange Composite Index in June.

This week the Wall Street Journal was also reporting that two China-based companies were forced to delay US dollar bond issues in Hong Kong, despite having no link to the reverse-takeover entities.

As the FT points out, it’s all proving very damaging to the China brand: “Buying a stock or bond with China or Sino in its name used to be a sure-fire route to riches, so strong was the demand for a piece of the world’s hottest emerging market. Now that trade has gone into reverse.”

Keeping Track: we first reported on Sino-Forest’s problems in WiC111, and they show no sign of abating. Chief executive and chairman Allen Chan resigned on Sunday after the Ontario Securities Commission said the company may have exaggerated timber holdings, the charge first made by short seller Muddy Waters in June. On Monday, Moody’s downgraded $1.3 billion of Sino-Forest debt to Caa1 from B1. Trading in the firm’s Canadian-listed shares has also been suspended, said the Financial Times. (Sep 2, 2011)


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