The muddy waters of disclosure
A central character in recent Chinese accounting issues is a man called Carson Block, who founded a research firm and investment manager called Muddy Waters. The name does not come from the blues singer, but a Chinese expression – muddy waters make it easy to catch fish. In other words, there are opportunities to make money when things are opaque.
A “strong sell” call Block made on Sino-Forest on June 2 set in motion its share-price collapse and subsequent investigations and lawsuits. Block does not pull his punches. The report, issued at a time when Sino-Forest stock was riding high, said the company “was aggressively committing fraud since its RTO [reverse takeover] in 1995” and was “a multi-million dollar ponzi scheme, accompanied by substantial theft”. More specifically, it claimed the company had dramatically overstated its forestry holdings and passed revenues through a host of intermediate companies in order to confuse auditors.
A look at the Muddy Waters research list shows only “strong sell” recommendations in all cases on companies, where fraud or at least mismanagement is alleged – Orient Paper, RINO, China MediaExpress and Duoyuan Global Water. In Block’s view, fraud is widespread in China and the big-four firms face great challenges in detecting it. One of his central points is that a company can, in a sense, fake transparency, in that it provides a great deal of information, but not the right sort. He argues that auditors may be looking for aggressive accounting, but not a situation where the underlying business does not even exist.
Still, there is another side to this coin. Block is not just an advocate of good governance in the mould of renowned Hong Kong gadfly David Webb, or Allen’s ACGA; he is there to make money and, in every instance, has built a short position in the stocks he then hammers in his reports, profiting from their subsequent share declines. Block is open about this: whenever interviewed, he points out himself that he is conflicted. He did not respond to requests for comment for this article.
However, the power of raising a red flag can be very destructive. Raising doubts about accounts is all but guaranteed to knock a share price hard and provide gains to anyone shorting the stock. The latest name to appear is Silvercorp Metals, another Toronto-listed Chinese company, which an anonymous whistleblower accused in early September of a “potential accounting fraud” worth US$1.3bn. Silvercorp has strongly denied this, publishing many documents to support its accounts. It has also retained analyst support, such as broker BMO, which maintained an “outperform” rating on the stock after the allegations. Also, it has apparently come out of a KPMG forensic audit looking clean and, as yet, the Ontario Securities Commission has taken no action. No matter, the share price fell 10% in a day anyway when the allegations were made. Its management said there had been a dramatic increase in short positions on its shares in the previous two months.
This is a central point: there is actually nothing new in irregularity in accounts for overseas-listed stocks. What has changed is scrutiny. “The difference is that people like Muddy Waters and other hedge funds are realising there are problems, short selling, putting out reports and publicly criticising,” Allen says. “They are essentially taking advantage opportunistically of a problem that is real, but I don’t think you will necessarily find in every PRC company listed in the US.”