Blogs & Comment

Sino-Forest versus the short sellers

A little-known research shop accuses Sino-Forest of fraud. Why are investors listening?

Shares in Sino-Forest, a TSX-listed company that operates forestry plantations in China, have plummeted 68% since a research firm issued an extensive report on Thursday accusing the company of committing a fraud of “stratospheric” proportions. Sino-Forest’s market cap has lost well over $2 billion.

The company denies all of the claims in the report, which accuses the company of falsifying data to inflate the size of its timbre holdings in China, among other offenses. The report was produced by Muddy Waters Research, a small shop that few had heard of before it zeroed in on Sino-Forest. The firm is operated by Carson Block, a U.S. lawyer and entrepreneur who has spent time in China. It’s no surprise that Block’s report includes a disclaimer that readers should assume the firm and its clients have a short position in Sino-Forest, meaning they will profit should shares fall.

A host of questions arise out of Block’s research and the ensuing fallout for Sino-Forest, which has offices in Mississauga, Ont. and Hong Kong. One is just how an obscure firm with hardly any track record can accuse a well-established company of fraud, and successfully send its shares into a free fall. Simply put, why would investors listen to Muddy Waters Research?

Part of the reason is that sentiment toward China and Chinese companies is turning. Concerns about the sustainability of the country’s overheated economy are mounting, and so has skepticism toward the accuracy of various companies’ financial statements. The past couple of years has seen a spate of Chinese companies going public through reverse takeovers—a somewhat murky process in which a private firm purchases a shell company that already trades on a foreign exchange. The U.S. Securities and Exchange Commission began investigating reverse takeovers last year, in fact. (Block points out Sino-Forest went public through a reverse takeover on the Toronto Venture Exchange long before the current wave of companies.)

Jim Chanos, the hedge fund manager who recognized the fraud at Enron before it collapsed, is a notable bear on China. He also has short positions in a range of Chinese companies that have gone public through reverse takeovers in the U.S. “Almost all of them have odd-looking financial statements,” he told Bloomberg Television recently. The demand for shorting these companies is now so great that Chanos says it’s increasingly difficult and expensive to borrow shares to sell them sort. “We wish we could borrow almost all of them.”

Investors are skittish toward Chinese companies amid all of the skepticism, and such firms are undoubtedly easy targets for short sellers. Sino-Forest may just be the latest example. A Bloomberg article notes short sellers have borrowed a stunning 82% of the company’s lendable supply of shares.

None of this is to defend Sino-Forest or make an argument that it is simply the hapless victim of short sellers. Serious questions have been raised, and Sino-Forest has set up a special committee to deal with the accusations. Block’s report, at 39 pages long, is robust, if nothing else. He’s also provided more than 60 documents to back up his claims. Block says he spent two months investigating Sino-Forest, employing a team of 10 professionals with expertise in accounting, law, finance and manufacturing. “We are confident that we have brought more expertise, time and money to bear in analyzing [Sino-Forest] than has any investor or bank—by a substantial margin,” he writes. 

It is now incumbent on other analysts, investors and regulators to exercise similar scrutiny.