Muddy Waters LLC, whose analyst reports triggered $7 billion in losses for Chinese stocks, used an unlikely secret weapon for its research: the public website of the U.S. Securities and Exchange Commission.
Carson Block, the 36-year-old short-seller who heads Muddy Waters, said he’s an avid reader of letters from the SEC’s corporation-finance experts to executives about the adequacy of disclosures in regulatory filings.
“The CorpFin accountants do a good job of spotting issues in the companies’ filings,” said Block, co-author of “Doing Business in China for Dummies.” “We’ve read some astute questions from CorpFin on a range of issues.”
Informed by such correspondence, the research firm’s 2010 report on Chinese waste treatment company Rino International Corp. (RINO) helped drive that firm’s stock from $13 to almost zero, erasing about $370 million in market value. It wasn’t a fluke.
To see the SEC's letters to Rino, click here.
Block gained fame for his short-selling calls on Chinese stocks after regulators halted trading in four of his first five targets, starting in June 2010. A lawyer and a New York native who founded Muddy Waters in 2010 in Shanghai, Block moved the company to Los Angeles later, saying Chinese officials were harassing his analysts.
The SEC, set up in 1934 to lift confidence in securities markets during the Depression, reviews 4,000 companies a year with special attention to new filers and industries in the spotlight, from Facebook Inc. (FB) to big banks. SEC letters and company responses aren’t posted to the regulator’s website until a month after they are sent, receiving no fanfare to alert interested investors.
As a result of the correspondence, the agency often forces companies to amend or make additional disclosures to inform investors of material risks. Some investors spot the required amendments to annual reports or registration statements. What’s missed by many is the detailed discussion of shortcomings in a company’s business that can warrant a bet against the stock.
Take the backstory about Rino in its correspondence with the SEC. As early as 2007, the agency quizzed Rino over the departure of its accountant, saying it must disclose any disputes with professionals in its filings. Rino at first insisted there were none.
The SEC pushed back, telling the company that investors must be told if an auditor expressed “uncertainty regarding the ability to continue as a going concern.” Rino amended a filing to say there were no disagreements over financial statements -- “except” that the auditor doubted the company was viable.
Four years later, the SEC stopped trading of Rino because it didn’t tell investors that investigators hired to probe fraud allegations had also left. By then, Rino had fallen from $34, briefly becoming the Nasdaq’s top short-seller target. Block piled on with his Nov. 10, 2010, report.
That report finally caught the attention of Rino holders who had missed or ignored accounting-violations clues in SEC letters, perhaps dazzled by the lure of riches to be made by investing in a booming China. Investment advisers were touting China’s gross domestic product, which the World Bank said rose 10.4 percent in 2010 and 9.2 percent in 2011.
That growth helped drive up the price of PetroChina Co. (857) enough for it to pass Exxon Mobil Corp. as the world’s most valuable company by market capitalization in 2009.
Roth Capital Partners, a U.S. investment bank with an office in Hong Kong that’s been bullish on Chinese stocks, said in 2010 that China’s growth would outpace other economies “for the foreseeable future,” boosting the country’s U.S.-listed stocks.
While Block was getting started with his research, China fans clung to shares such as Sino-Forest Corp., now bankrupt, and New Oriental Education & Technology Group (EDU) Inc. New Oriental, usually known as EDU for its stock symbol, was investigated by the SEC and staved off a stock collapse until 2012, perhaps because investors didn’t do their SEC homework, said Peter Henning, a former SEC lawyer who teaches at Detroit’s Wayne State University.
“That’s the obligation of every investor,” he said. “A company amends its filings because information is already out in the market that needs to be corrected or updated.”
Chinese companies in recent years were the object of at least 19 lawsuits and other enforcement actions targeting 64 defendants in all, according to SEC data. They ranged from China Natural Gas Inc., accused last May of defrauding investors, to now-defunct China Energy Savings Technology Inc., sued in 2006 for stock manipulation. Deloitte & Touche LLP was among at least six auditing firms named in four of the actions. In addition, trading in seven Chinese companies’ shares, including Rino’s, was suspended.
About 50 foreign securities have been deregistered in recent years and more than 40 foreign issuers were sued for fraud, sometimes years after early warnings about accounting irregularities appeared in agency correspondence.
Pushing foreign executives toward use of U.S. reporting standards is the daily work of the SEC’s corporation-finance teams, agency correspondence shows. For example, Rino was ordered to tell shareholders about insider ties that might hurt their interests.
The SEC noticed in a registration statement that Zou Dejun, Rino’s CEO, and Qiu Jianping, its board chairman, were married. The agency asked for a statement about the potential conflict that might cause. Rino added a disclosure in 2008 that the couple then owned 100 percent of Rino equity and also said: “As such, we cannot assure you that Mr. Zou, in his capacity as our CEO and director, will act in the best interest of the company.” Rino was eventually listed in the U.S. in May 2008.
EDU, a Muddy Waters target that says it is China’s largest private education provider, had difficulty calculating its net income initially. One affiliate supposedly contributed 99 percent of revenue and only 27 percent of net income. Challenged by the SEC, the company agreed to show in future filings that almost all of net income came from the affiliate -- if its various parts were added up.
EDU also had to be told there is a legal form for certifications, and it can’t be changed to use different words or punctuation in endorsements of its financial information.
After being scrutinized from 2009 about everything from revenue reporting to terms of contracts, EDU said last July that the SEC was investigating whether its Beijing New Oriental Education & Technology entity was appropriately consolidated in financial statements. The next day, Muddy Waters posted a “strong sell” recommendation on its website, saying “it is probable that EDU will have a significant restatement” of results. Block said he read the SEC letters sent to EDU, and the company’s responses.
“The back and forth between the two was overall fairly helpful to us during our research,” he said.
In one letter, EDU responded to the SEC query about the affiliate’s net income contribution. Going through the numbers, Block said he believed EDU failed to include the effect of certain taxes that could have amounted to about one-seventh of reported 2008 profit. A later disclosure gave different results for the same entity, he said.
Sisi Zhao, EDU’s investor-relations director, didn’t respond to e-mails asking for an update on the SEC probe and comment on Muddy Waters’s report. Rino Chief Financial Officer Ben Wang didn’t answer e-mails seeking comment on Rino’s experience with the SEC or Muddy Waters. Byron Roth, Roth Capital’s chief executive officer, didn’t respond to e-mails seeking comment on the firm’s bullishness on Chinese shares.
Despite SEC letter data, Block hasn’t had much success keeping down shares of Shanghai-based advertising firm Focus Media Holding Ltd. (FMCN), which is going private with Carlyle Group LP. He has posted six reports on the company on Muddy Waters’s website since Nov. 21, 2011.
Focus Media said Jan. 18 that the SEC was looking at its past acquisitions. The SEC had queried the company in 10 letters, prefiguring its current investigation.
Writing down eight newly bought advertising businesses and handing them back to their owners at a discount, Focus Media was told in 2010 to disclose losses and explain this “apparent pattern.” Muddy Waters noted the trend in a Nov. 21, 2011, report, saying investors should worry “where cash actually moved.”
“There were some notable exchanges” between the SEC and Focus Media, Block said.
Reading SEC demands in the 2010 letters for more disclosure on Focus Media’s sales of stakes in Internet ad-service company Allyes Information Technology, Block concluded the regulator found the deal “questionable,” he said.
Using a list drawn up for the SEC of acquired mobile and Internet ad companies that Focus Media resold to their owners, Block was able to research the purchases and conclude they never occurred, he said.
Focus Media briefly fell to $15.43 from $25.50 after Block’s first report said its ad network was smaller than claimed. The shares rebounded to the $20 range after an August buyout bid by Carlyle Group-led investors, which was accepted in December.
Focus Media has said it is cooperating with the SEC in its probe. Jing Lu, a company spokesman in Beijing, didn’t answer e- mails seeking comment on Block’s reports.
As warnings, SEC letters aren’t as vivid as Block’s reports and stories. Writing of “cooked books” and “sub-par” technology, he said five out of nine “purported” customers he interviewed denied buying Rino’s desulfurization systems and that one buyer was “not satisfied.”
In the Rino case, Block beat the SEC to the punch in saying the company had two sets of books. He had read Chinese disclosures and saw that 2009 China revenue was 94 percent lower than its U.S. numbers.
“In reality its revenue is under $15 million,” his November 2010 report said.
The SEC mentioned for the first time “the existence of two separate and materially different sets of corporate books” when it halted trading in April 2011.
The regulator asks foreign companies how they report at home “as appropriate,” SEC spokesman John Nester said.
On the other hand, the SEC pushed Rino starting in 2008 to disclose how sales were counted, how it depended on customer approval, and why it had so many paper assets or receivables -- all issues later taken up by Block.
The SEC forced Rino CEO Zou Dejun to revise a 2008 registration statement eight times over seven months. An Aug. 19, 2008, report dealt with “non-reliance on previously issued financial statements.” The report was demanded by the SEC in an Aug. 11, 2008, letter reminding Rino that it had restated results after “material errors.”
Sometimes Block does on-the-ground reporting to supplement his review of filings and SEC correspondence. After visiting the steamy factory and old machinery operated by Baoding, Hebei- based Orient Paper Inc., he decided to short the company’s stock, he told Bloomberg News last year.
In a short sale, investors borrow stock from current holders and sell it, hoping to profit by repurchasing the securities later at a lower price and returning them to the holder.
Some China stocks dipped on revised filings required by the SEC, indicating Block wasn’t alone in watching disclosures. Still, with investor mania about China strong, some of those stocks went up again.
Fushi Copperweld Inc., made to disclose how a possible $7 million legal judgment would hurt liquidity, fell from about $9 to $7 after the company said June 9, 2009, that it owed the money. The stock surged to $12.76 April 2010 and was taken private in December 2012 at $9.50.
Rino tumbled to $2 from $10 after a June 11, 2008, annual report revision of “material errors.” The next year it was 17 times higher.
“No question, a disclosure is more important than a short sale report,” said retired short seller David Rocker of New York-based Rocker Partners, whose past targets included AOL Inc. “Both are merely starting points, and then you should do your own homework.”
Sometimes Muddy Waters goes where the SEC can’t. It targeted Sino-Forest, the bankrupt tree grower delisted from the Toronto Stock Exchange, and Olam International Ltd. (OLAM), the Singapore-backed peanut merchant. Both escaped SEC grilling because they weren’t required to file disclosures in the U.S.
While the SEC provided investors some of the earliest warnings about Chinese accounting in its correspondence, it became more direct after former Chairman Mary Schapiro got an April 2011 letter on the subject from Patrick McHenry, a North Carolina Republican who chairs the House financial services and government reform committees.
“Review the company’s SEC filings,” the SEC said in a June 2011 bulletin on its website about Chinese companies. “Be aware of companies that do not file reports with the SEC. Be skeptical.”
The answer for some Chinese companies seeking to avoid SEC scrutiny is to flee U.S. exchanges. Some have done so, citing stringent SEC rules. Focus Media, whose $3.7 billion buyout will be China’s largest, was one of 49 companies that said it will go private, Roth Capital said in November.
As useful as the hidden-in-plain-sight SEC correspondence can be to investors as an early warning of unknown risks, the letters might be even more useful if published in real time, Block said.
“In the investment world, information is always more valuable when made public sooner,” he said. “SEC correspondences sometimes contain important red flags, and publishing them sooner would give more investors a chance to read them before making investment decisions.”
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