Can Asia's CFOs Repel the Short-Sellers?

It is every CFO’s nightmare in the age of the Internet and instant communications.

On June 2, little-known Muddy Waters Research accused mainland Chinese plantation tree owner Sino-Forest Corporation of overstating the extent of its timber holdings and committing other instances of fraud. Sino-Forest CFO David Horsley and his CEO, Allen Chan, denied the allegations, but investors took fright and drove down the stock price of the Toronto-listed company.
Never mind that Muddy Waters -- its name references a proverb that muddy waters make it easy to catch fish -- is also a short-seller with a strong interest to see the stock price implode. After closing at C$18.21 on June 1, Sino-Forest fell 20% to C$14.46 on June 2. The stock plunged to its lowest level on June 21, when it traded at C$1.99 – down 89% from June 1. Sino-Forest has now recovered somewhat, closing at C$3.20 on June 30, but that’s still far lower than before the Muddy Waters report.
Other companies are getting muddied, too. Hong Kong-listed organic vegetable grower Chaoda Modern Agriculture fell 28% from HK$3.97 on June 1 to HK$2.87 on June 6, while processed-meat supplier China Yurun Group slid 31% from HK$28 on June 22 to HK$19.38 on June 28. Both were rumoured to be the subject of a Muddy Waters report.
Muddy Waters did come out with a report on June 29, but the target was Shanghai-based semiconductor maker Spreadtrum. The company’s depositary receipts listed on Nasdaq fell as much as 34% before clawing back most of their losses to close at US$12.49, down 3.5% for the day. It fully recovered on June 30.
Other players may be joining the game. Allan Matheson, managing director of Hong Kong due diligence firm Blue Umbrella, is seeing a rise in requests for “fishing expeditions” into the financial statements of mainland Chinese enterprises. But, he says, “most of the companies we’ve researched ultimately receive the green light from our clients.”   
China Syndrome
What’s going on? Call it the China Syndrome. In recent months, questions have been raised about the financials of at least 13 mainland companies listed in the US and Hong Kong, among them China Agritech, China MediaExpress Holdings, China Century Dragon Media, China Forestry Holdings, Longtop Financial Technologies and Real Gold Mining. Trading in their shares has been suspended and several companies were delisted.
In this environment, it is easy for a mainland Chinese company to be tarred with the same muddy brush, regardless of how strenuously company officials deny the allegations. Sino-Forest has engaged PricewaterhouseCoopers to conduct an independent review, but nervous investors remain disinclined to give the company the benefit of the doubt.  
High-profile hedge fund manager John Paulson is one of them. He has been supportive, CFO Horsley initially told Canada’s The Globe and Mail newspaper. “We are certainly in conversation with him and others to talk about what is going on and things that we need to be doing and the alternatives that the company could undertake to respond to some of these allegations.”
But by June 17, Paulson’s various funds had completely disposed of their combined 34.7 million Sino-Forest shares, equivalent to 14% of the company. “We believe significant uncertainties exist,” Paulson told his investors in a letter. “Even if Sino-Forest’s special committee investigation clears management and supports the public disclosures and financial statements, the stock may remain depressed for an extended period of time.” A Canadian regulator, the Ontario Securities Commission, has launched a probe of Sino-Forest.
Like Madoff?
In truth, the Muddy Waters report reads more like a diatribe than a considered and objective analysis. It is also riddled with inconsistencies. For example, it accuses Sino-Forest of overstating its timber investments in Yunnan by US$900 million in one section, and then pegs the amount at a lower US$800 million elsewhere in the report. The average price per cubic metre of broadleaf timber is given as RMB102 – and US$102 in a footnote (the dollar figure is the correct one).
Muddy Waters is anything but muddy in its judgement, however. In the bullet points to the 40-page report, it compares TRE – that’s Sino-Forest’s stock code in Toronto – to US fraudster Bernie Madoff. “Like Madoff, TRE is one of the rare frauds that is committed by an established institution,” the report charges. “In TRE’s case, its early start as an RTO [reverse takeover] fraud, luck, and deft navigation enabled it to grow into an institution whose ‘quality management’ consistently delivered on earnings growth.”
“The foundation of TRE’s fraud is its convoluted structure whereby it runs most of its revenues through ‘authorized intermediaries’ (‘AI’),” the report goes on. “AIs supposedly process TRE’s tax payments, which ensures that TRE leaves its auditors far less of a paper trail.”
Muddy Waters also alleges that TRE provides Jaako Pöyry, a global independent forestry consultancy, with “fraudulent data” and therefore the independent reports the well-known consultant produces on TRE’s purchased and planted forestry holdings “do nothing to ensure that TRE is legitimate.”
Factual Nuggets
Pöyry, which has been valuing TRE’s forestry assets since 2000, estimated that TRE’s claimed 573,644 hectares of purchased forest estate was worth US$2.7 billion and its claimed 46,467 hectares of planted forest estate was worth US$177.3 million as of December 31, 2010.
Crucially, Pöyry makes clear that it “has neither verified the authenticity of the total area of forest said to be owned, nor its ownership . . . Rather, Pöyry has relied on the description of the stocked area of forest that is said to be owned, by special, age and location, as was provided by SFC [Sino-Forest Corp.].”
Beyond Muddy Waters’ fractured purple prose and self-congratulatory statements (“Were Muddy Waters not to have come along,” the report grandly states, “it is likely that this fraud could have continued for a few more years and billions of dollars more”), the issue of hectarage is one valid nugget to raise.  
Muddy Waters questions Sino-Forest’s disclosure in 2007 that it had entered into a master agreement with Lincang City in Yunnan province to buy up to 200,000 hectares of plantation trees. It claims to have examined government approval letters that indicate that Sino-Forest has agreed to acquire only 6,667 hectares in Lincang City. Quoting an agent in Yunnan, the report said the company purchased additional 13,333 hectares in two nearby counties – but the total is still way below 200,000 hectares.
The hectarage gap, if proved, is significant because the company reported US$231.1 million in standing timber sales from Yunnan last year (total standing timber sales was US$507.9 million), indicating, according to Muddy Waters calculations, that Sino-Forest had purchased at least 25,000 hectares of forests in Yunnan.
As Muddy Waters asserts, however, it can validate only 20,000 hectares of forestry land that Sino-Forest purchased in Yunnan. It concludes that much of the total hectarage that Sino-Forest says it owns is bogus, and that, therefore, most of US$3.05 billion it has raised from the capital markets has not been spent on forestry purchases as intended.
“TRE raises cash from the financial markets, purportedly buys forestry assets, which are then valued at a significantly higher level by Pöyry (which takes TRE’s word on the size and scope of the acquisition at face value), leading to a higher reported net asset value which acts as the support or collateral for an even larger capital raise,” Muddy Waters charges. “The first investor relies upon the new capital to generate the return, thereby fitting a classic Ponzi scheme definition.”
Staunch Denials
Sino-Forest insists that the purchased and planted hectarages it reports are accurate. “Muddy Waters’ shock-jock approach is transparently self-interested and we look forward to providing our investors and other stakeholders with additional information to rebut these allegations,” CEO Chan shot back.
The company is apparently pinning its hopes on PwC’s independent investigation, which will presumably supply this additional – and independently verified – information. In the meantime, however, Sino-Forest continues to operate under a cloud. So are the likes of Chaoda, Yurun and other mainland Chinese companies that are rumoured to be in Muddy Waters’ sights.
If it’s any consolation, Muddy Waters’ broadsides against Spreadtrum have not been as successful, given the stock’s rapid rebound. Possibly it’s because of the format – the attack is in the form of an open letter to company chairman Leo Li. Among the 15 questions were insinuations about the departure of company founder Ping Wu and CFO Richard Wei in 2009. Why did the two men leave “when the sales pipeline was so promising?” Muddy Waters asked.
“Given that the turnover in the auditor, audit committee, and CFO position occurred while [Spreadtrum] was in the midst of a stunning turnaround, did the resignations and removal have anything to do with discomfort about [the company’s] accounting?” And if Spreadtrum made US$75.3 million in pre-tax profits in 2010, another question went, “why didn’t it make any cash tax payments?”
“We believe that there is a high risk of material misstatement in the reported financials since the time of Dr. Ping Wu’s resignation,” Muddy Waters said. Chairman Li strenuously denied it. “Our performance is very solid,” he told Bloomberg on June 29. “The allegations, none of them, are true.”  The next day, the company announced its first ever cash dividend, which boosted the share price – and stymied Muddy Waters’ short positions, at least temporarily.
Fighting Back
It remains to be seen how all this will pan out. The experience of Orient Paper Inc., which is traded on the NYSE Amex Equities board for small companies, may be instructive.
Around this time last year, Muddy Waters targeted Orient Paper Inc., a Hebei-based company that turns waste paper into printing, photo and packaging products. It accused management of a host of governance sins, including misappropriation of funds, overstatement of revenues and fraudulent disclosures regarding its top ten customers. Orient Paper’s stock price imploded.
The company fought back. CEO Zhenyong Liu told anyone who would listen the story of how Bill Block and his son, Carson Block, who is co-founder of Muddy Waters, toured Orient Paper’s plant in January last year “for less than an hour and then offered to publish a positive research report in exchange for a large sum of money and equity compensation.”
The company declined. “The next we heard from these gentlemen was on June 28, 2010, when they published a 30 page report under the name of a new firm named Muddy Waters  . . .  alleging that our company was a fraud and that management had misappropriated investors' money,” Liu recounted.
Orient Paper branded the allegations “categorically false” and engaged Deloitte & Touche Financial Advisory Services, US law firm Loeb & Loeb and TransAsia Lawyers in China to assist its audit committee with an independent investigation. Completed last November, the probe found no evidence to support Muddy Waters’ accusations. In a June 21 interview with Bloomberg, Liu said he might consider legal action against Muddy Waters.
That’s a course of action US home builder Lennar took in 2009 against another short-seller, Barry Minkow, who had published an Internet report called “Top 10 Red Flags for Fraud at Lennar Corp.” Minkow pleaded guilty earlier this year of conspiring to manipulate Lennar’s stock price by making false and misleading statements. He was also ordered to pay the company US$584 million in damages.
Optimistic Trend
Liu urges Chinese companies to “conduct the third-party investigation like we did” but do it better “in order to shut others’ mouths.” Not that Muddy Waters has been silenced. “The market clearly doesn’t believe Orient Paper,” Block wrote in an email response to questions posed by Bloomberg. “Orient Paper never addressed many of our allegations, and it took months to address the few that it did.”
The company’s stock price continues to languish at the US$3 level, down more than 60% from before the Muddy Waters report, although that is considerably higher than Muddy Waters’ US$1 valuation. “When a [short-seller] attacks and is substantially wrong and causes millions in damages, investors lose quite a bit of money but nothing happens [to the short-seller],” Orient Paper independent director Drew Bernstein bemoaned to the website MarketWatch.
The phrase ‘substantially wrong’ acknowledges the possibility that there may be instances of shortcomings in corporate governance, financial management and tax and other governmental relations among companies, which is perhaps to be expected in a still evolving market like China. The country’s immature commercial, legal and other infrastructures may be forcing companies to resort to creative ways of doing business, which may raise red flags in the overseas markets where those companies are listed.
“We do find issues such as misconduct, fraud, political exposure and conflicts of interest,” says Blue Umbrella’s Matheson. “We have found that some companies in China, as well as other developing markets across Asia, have kept multiple books of accounts.” In these dynamic markets, he adds, “it’s important to corroborate what’s publicly reported with other data points.”
“We are actually quite optimistic and see that the overall trend among Chinese companies is towards greater transparency and stronger corporate governance,” Matheson adds. He makes clear that “the majority of the companies we research are [validated as] legitimate businesses created and build by hard-working legitimate business people.”  
For CFOs and their company that may come under attack from Muddy Waters and other short-sellers, the challenge is to prove that they are part of that majority.
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation.

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