First published in July 2011. The research was well-founded and Sino-Forest duly disappeared.
“To the best of our ability and belief”, runs the standard legal disclaimer on the research report I have just been reading, “all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable”. The issuer of the report, it goes on, “makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use”.
Such legalese is now familiar to every investor and is read (or rather ignored) many thousands of times every day. Yet sometimes, as on this occasion, it carries an extra resonance because of the explosive nature of the material to which it relates. The issuer of this report is Muddy Waters Research, a small and hitherto little-known Canadian research firm that seeks to pick holes in the business models and accounting statements of listed Chinese companies, with the intention of taking aggressive short positions in those stocks.
So far the firm has published research on five stocks, and caused share price falls of at least 50% in all of them, most recently by making claims about Sino-Forest, a timber company that has been listed on the Toronto Stock Exchange since 1994. Its shares have fallen from a peak of $25 a share to less than $3 a share since Muddy Waters Research “Initiated coverage” on the stock with a “strong sell” recommendation four weeks ago.
I think it is fair to say that even “strong sell”, although refreshingly unambiguous, hardly does justice to the hatchet job that Muddy Waters Research has set out to do on its target company, which it openly accuses of being a fraudulent enterprise with characteristics of a Ponzi scheme. (You can read the charge sheet on the Muddy Waters website, where its research reports are available for anyone to read if they agree to the terms and conditions and note the legal disclaimers).
Unsurprisingly the company has reacted strongly to the report and its damaging accusations, which its CEO Allan Chen describes as “inaccurate and unfounded”. It has set up a committee of independent directors to examine the accusations, and hired the accounting firm Pwc to assist them. You can read its initial response and an interview with Mr Chan at http://www.sino-forest.com. Sino-Forest is audited by Ernst & Young, several current or former employees of which are on the board of the company.
The case of Sino-Forest has grabbed the headlines not just because of the size of the company – its market value was north of $4 billion before the report came out – but because of the illustrious names of those who have been large investors in the company. These include John Paulson, the hedge fund titan who made a fortune out of shorting the subprime business ahead of the global credit crunch.
Having remained silent for two weeks while he investigated the allegations, Mr Paulson has since sold his entire 14% stake in the company, swallowing the 85% loss from its peak market value. In a letter to investors he describes the outcome as “disappointing”, and argues that as a “passive investor” he is just as reliant on the accounts and public information issued by the company as any other investor. (Some hedge fund investors might think they are paying for more exhaustive due diligence). The 85% collapse in Sino-Forest’s share price is the largest contributor to the 15% loss that Paulson’s Advantage fund is reported to have recorded in the first half of 2011.
I should make it clear that I have no idea whether the allegations made by Muddy Waters Research are true or not. It is impossible for an outsider to judge. Clearly however the allegations are serious, and that, judging by the share price reaction, the markets have yet to be convinced that Sino-Forest will come up with a convincing explanation to restore its former market standing. The findings of the Pwc and board investigations will take some months to complete. The Ontario Securities Commission is also investigating.
By the same token, it is evident that Muddy Waters Research has taken an extremely aggressive stance which will surely put its own existence at risk if the target of its attentions is able to demonstrate that its allegations are either wrong or malicious in intent. I very much doubt, in that case, whether the disclaimer I mentioned at the outset will save them from an expensive and litigious future. The fact that they have made their research public would seem to raise the stakes by some margin.
The Sino-Forest case raises plenty of interesting and important issues. For example, can auditors based in one country (Canada) effectively audit the accounts of a company whose assets – reportedly millions of acres of forest which Muddy Waters Research claims they may not own – are spread across a vast country thousands of miles across the Pacific? Are companies which, like Sino-Forest, obtain a listing in Toronto by means of a reverse takeover of a Canadian listed company somehow finding a way past rigorous listing requirements? Should not Sino-Forest’s curious practice of generating sales through unnamed authorized intermediaries have raised red flags before now?
On the other side, is it right that an investment firm should profit from its short positions on a company about which it has published serious allegations that will take months for the company to prove or disprove? Although in one sense it is only the mirror image of investment banks promoting stocks where they stand to make millions in fees, the practice leaves an uncomfortable feeling. Recent experience argues however that negative research, however motivated, can be seen as being in the public interest. One lesson from both Enron and the subprime crisis is that there are too few organizations with a vested interest in challenging the accounting practices and business models of large corporate entities.
For a variety of reasons, in such cases both regulators and auditors have shown themselves not to be up to the task of protecting investors. A highly incentivized private sector agent with the courage to do its own forensic research and take the consequences of being wrong might start to tilt the balance against the heavy vested interests ranged on the side of corporate entities. Whatever the rights and wrongs of the specific Sino-Forest case, in my book the investment world needs more risk-taking forensic analysts to do what Muddy Waters Research does.
Jonathan Davis 