Muddy Waters Research Is a Thorn to Some Chinese Companies
Carson C. Block makes even Wall Street cringe.
Last week, the founder of the investment firm Muddy Waters Research issued a scathing report on a Chinese forestry company, calling it a “pump and dump” scheme that has been “aggressively committing fraud.”
The remarks set off a sharp sell-off in shares of the company, Sino-Forest, prompting Canadian authorities to temporarily halt trading. Since the report, the stock has fallen more than 70 percent, erasing billions of dollars in value from a company whose investors include Paulson & Company, the hedge fund run by the billionaire John A. Paulson.
“They overstated assets by billions of dollars and funneled money to an undisclosed subsidiary,” said Mr. Block, whose firm is based in Hong Kong and the United States.
Sino-Forest vehemently denies his assertions and released evidence to support its position. Canadian regulators, following the Muddy Waters report and the stock volatility, opened an investigation into the matter.
"Business deals are rife with value subtraction layers. The more opaque they (the Chinese) make it, the easier it is for them to siphon off money."
Mr. Block is delivering a controversial message to investors enamored with Chinese companies: buyer beware.
He has set his sights on a specific group of stocks that access the public markets through a back-door method known as a reverse merger. In such deals, private companies acquire a public shell company in the United States or Canada. They can quickly raise capital while avoiding the scrutiny and the cost of the traditional listing process. Today, there are more than 500 such Chinese companies in the United States, collectively worth billions of dollars.
On Thursday, the Securities and Exchange Commission warned about the potential risks of investing in reverse-merger companies, including murky financials and complicated ownership structures. The S.E.C. says it has suspended trading on more than a dozen stocks in this category, which lacked “current, accurate information about these firms and their finances.”
“This is an area of heightened scrutiny for us,” said Kara N. Brockmeyer, an assistant director in the agency’s division of enforcement.
Research firms like Mr. Block’s Muddy Waters, Citron Research and GeoInvesting are taking direct aim at reverse mergers they say have dubious practices. The organizations are issuing research reports, posting surveillance videos and collecting corporate documents. The firms say it is regulation in an area with little oversight.
“We had counted on the fee collectors — the investment banks, the accountants and the lawyers — to tell us what was right,” says Dan David, vice president at GeoInvesting, a micro-cap research and investment house. “Now, we’re doing our own due diligence, and hiring people in China to investigate.”
But critics contend this emerging force has a financial motive to exaggerate and even fabricate information. Players like Mr. Block often place bets against the companies. The so-called short-sellers profit when the shares decline. Some fear their bearish research amounts to market manipulation.
“There are fly-by-night analysts that are rumor-mongering because they are admittedly short the stock,” says Perrie M. Weiner, international co-chairman of the securities litigation practice at DLA Piper, who represents reverse-merger companies in regulatory disputes. “If you’re short the stock and you’re spreading negative rumors about the company, you better be right.”
Mr. Weiner said cases involving reverse mergers now composed a third of his entire workload, up from a small fraction just two years ago.
Sino-Forest has said it is considering legal action against Muddy Waters, calling its report “inaccurate, spurious and defamatory.” The company has also been posting documents on its Web site to refute Mr. Block’s accusations, including bank statements and land purchase agreements.
Mr. Block, 35, is the unofficial spokesman of this contentious movement.
The son of a Wall Street broker, he grew up in New Jersey, studied finance and Chinese at the University of Southern California, and earned a law degree from Chicago-Kent College of Law. In the 2005, he joined the Shanghai offices of the law firm Jones Day. Tired of being a corporate lawyer, Mr. Block started his own self-storage company, Love Box, and co-wrote a book, “Doing Business in China for Dummies.”
Then early last year, his father, William, the founder of W.A.B. Capital, asked him to research a potential investment, Orient Paper. As part of the due diligence, Mr. Block and a friend traveled to China to visit the company’s headquarters. He said it was a Potemkin Village, littered with “junk machinery” and “trash.”
“They appeared to be transparent, but they had fake transparency,” Mr. Block said. “The funniest thing was they had a large heap of scrap cardboard. They listed this on the books as raw material worth millions of dollars.”
Shortly after the trip, Mr. Block wrote a sensationalistic report describing what he saw as fraud at Orient Paper and encouraged traders to sell shares of the company. He shorted the American-listed stock, which plummeted to around $4 from $15 in late 2010.
Orient Paper called the report “reckless” last November. It also suggested that Mr. Block and his father had tried to extort money from the company before publishing the report. Mr. Block denies the allegation.
The experience led to a new career. Since then, Mr. Block has issued damaging reports on four other companies. He approaches each case like an investigation, sifting through corporate registration documents and even hiring private investigators to pose as potential business partners.
“It’s amazing what edge you can get when you just read,” he said referring to company financial statements.
In the Sino-Forest case, he and his team of lawyers and private investigators spent two months poring over 10,000 pages of documents. His 39-page report concluded that Sino-Forest lied about assets and timber holdings. He posted photographs, charts and diagrams on the firm’s site in support of his claims.
“As Bernard Madoff reminds us,” Mr. Block wrote in the introduction to the Sino-Forest research, “when an established institution commits fraud, the fraud can become stratospheric in size.”
After the series of negative calls decimated the stocks of the Chinese companies, Mr. Block says he has received death threats and harassing phone calls and e-mails.
But he said he would continue to publish his research. He says he believes investors and auditors need to understand how businesses operate in China.
He explains by way of the firm’s name, Muddy Waters. It’s derived from a Chinese phrase that says the easiest way to catch fish is by muddying the water, forcing it to the surface.
“You kick up the silt, and they rush to the top of the water,” he said of the Chinese proverb.
“This explains a lot about how things work in China,” Mr. Block added. “Business deals are rife with value subtraction layers. The more opaque they make it, the easier it is for them to siphon off money.”