Short Seller Drops Muddy Waters Model for SEC

Short seller Jon Carnes made millions of dollars publishing anonymous reports accusing Chinese companies of fraud. Now settled in Vancouver after fleeing threats of violence in China, he’s trying another business model: providing tips to the U.S. government.

The 38-year-old says he’s applied to the U.S. Securities and Exchange Commission for whistle-blower status in connection with lawsuits filed by the regulator accusing two executives at China’s Puda Coal Inc. of fraud. The SEC program, established following the 2010 Dodd-Frank Act, gives informants a share of proceeds if their information leads to more than $1 million in penalties.

Carnes, who at one time worked with Muddy Waters LLC founder Carson Block, is among short sellers who have published fraud allegations as they try to drive down share prices. While the high-stakes strategy paid off for Carnes, who posts his anonymous reports on his website, it has also brought him lawsuits and physical threats to some of his associates. Carnes’ experience in China and his decision to help the SEC may illustrate the limits of short selling in a country where foreign investors have fewer legal rights compared to North America.

“I would never have done AL if I could go back,” Carnes said, referring to the website’s initials. “Our friends who didn’t publish anything and just shorted, they made just about as much money as we did without any fallout.”

Reverse Takeover

Congress expanded the SEC’s whistle-blower provisions after the agency failed to act on tips it received about Bernard Madoff’s multibillion-dollar fraud. Under the program, a whistle-blower can be awarded 10 percent to 30 percent of any money the SEC collects, depending on how central the tip was to proving the case. The SEC said in a November report that 334 tips had been received under the program in its first 50 days of operation.

“When we discovered this last year, we thought this was perfect,” said Carnes in his first public comments about his short selling. “One thing that’s very helpful for us in protecting ourselves is if these Chinese companies think the SEC is listening to us.”

Puda Coal is a so-called Chinese reverse takeover company, after it acquired another company to gain a share listing in North America rather than holding an initial public offering. The allegations made against Puda and other companies by short sellers such as Carnes and Block have heightened investor scrutiny of reverse-takeover companies trading in the U.S. and Canada. The Bloomberg Chinese Reverse Mergers Index fell 62 percent last year.

‘Good Story’

In a short sale, a trader borrows shares and sells them. If the price drops, the trader profits by buying back the stock at a lower price, repaying the loan and pocketing the difference.

Negative research reports like those published by and Muddy Waters attract attention because “people like the drama -- it’s a good story,” says Kevin Carter, co-founder and chief executive officer at Baochuan Capital Management LLC in Walnut Creek, California, which oversees more than $50 million of investments. “These guys are yelling fire in a movie theater.”

Carnes, who is married with children, wore open-collared shirts and a black Ermenegildo Zegna jacket at two interviews in downtown Vancouver last month. He said he made a $2.5 million profit shorting Silvercorp Metals Inc., a Vancouver-based company that mines silver in China. The shares slid 20 percent on Sept. 13, the day a report questioning Silvercorp’s deposits and production was published on

Police Investigation

The British Columbia Securities Commission is probing Carnes’ allegations about Silvercorp. Carnes says he’s cooperating with SEC investigators and Canadian police.

Lorne Waldman, a spokesman for Silvercorp, Richard Gilhooley, a spokesman for the British Columbia watchdog, and John Nester, an SEC spokesman, declined to comment. Sergeant Duncan Pound, a spokesman for the Royal Canadian Mounted Police, said an investigation by his force is continuing and declined to comment further.

A request for comment to Puda Coal’s offices in China wasn’t immediately answered.

Silvercorp named Carnes in a lawsuit filed in the State Supreme Court of New York alleging defamation. Sino Clean Energy Inc. and Deer Consumer Products Inc., also targets of reports on alleging fraud, have also each filed complaints in the same court alleging defamation.

Legal Bills

Helen Wang, a Deer spokeswoman, couldn’t be reached for comment. Jing Li, an assistant to Sino Clean’s chief executive officer, denied the short sellers’ allegations.

“We are very confident about the business fundamentals of our company,” Li said. “I’m not saying Chinese companies do not have certain problems, but making a profit by distorting facts and exaggerating minor problems is very unethical.”

Carnes, who said the Puda application for whistle-blower status cost him $50,000 in legal fees, also plans to seek whistle-blower designation in relation to Silvercorp.

“If even one settlement does come through, that could be a nice pay day, and maybe offset all the legal bills we’re piling up,” he said.

U.S.-born Carnes says his investment career began in 1991 with $3,000 earned from a part-time job at a fried-chicken restaurant in Columbia, South Carolina. Between 1996 and 2001, Carnes says he earned as much as $100,000 a day trading shares until the Nasdaq market changed its pricing to decimals from fractions, making his trading style unprofitable.

Vancouver Move

Carnes says he later worked with investor Andrew Worden on “long” investments in China. Worden, who runs Barron Partners LP, now a New York-based investor in clean energy, declined to comment.

To be closer to China, Carnes says he relocated to Vancouver from Las Vegas. He employed a group of graduates from the University of British Columbia to conduct due diligence on companies in China.

Carnes’ initial focus was on private investments in public equity, or PIPEs, in which investors acquire shares of a public company at a discount in exchange for capital. The buyer is then restricted from selling on the open market for a set period.

“He was never a promoter, he was just very, very, very cautious and he was the one who would go look and visit and see what was going on at these companies,” said Steve Mazur, a Pennsylvania-based private investor who invested with Carnes in two Chinese companies. “I don’t think he’s the type of guy who would make up things to make money.”

‘Low-Hanging Fruit’

Carnes said that when his due diligence found evidence of questionable practices at publicly traded companies, he decided to use it.

“When there’s so much low-hanging-fruit frauds, then you go get them as fast as you can,” he said.

Carnes says he first met Block in September 2010 to talk about a report on Orient Paper Inc. published by Block’s research firm Muddy Waters. Block -- the founder of a self-storage company in Shanghai called Love Box and co-author of “Doing Business in China for Dummies” (For Dummies, 384 pages, $21.99) -- subsequently cooperated in shorting Rino International Corp., a Chinese designer of wastewater equipment.

Muddy Waters said in a November 2010 report that Rino had exaggerated its revenue. Rino said in a filing eight days later that two years of financial statements weren’t reliable. The shares tumbled 67 percent that month in U.S. trading.

“Carson, overnight, was famous,” Carnes said. “The short sellers, Carson and us, really woke up to, wow, there’s a killing to be made here exposing fraud.”


Zach Kouwe, a spokesman for Block, and Rino Chief Financial Officer Ben Wang declined to comment.

“We were very shocked when we saw Muddy Water’s report because all the allegations were highly misleading and inaccurate,” Orient Paper said in an e-mail. “The company believes the allegations are false and their short selling is totally irresponsible behavior to not only the company but the entire market.”

Carnes and Block later split amicably, according to Carnes, with Block aligning himself with investors in Hong Kong.

Block published a Muddy Waters report in June that alleged fraud at Sino-Forest Corp., China’s largest forestry company. Sino-Forest fell 74 percent in Toronto, losing investors about C$3.3 billion ($3.3 billion), before the shares were suspended amid investigations by the Ontario Securities Commission, Canada’s top securities watchdog, and the RCMP.

Silvercorp Slump

Sino-Forest has denied the allegations and is suing Block for defamation. The Hong Kong-and Mississauga, Ontario-based company owes bondholders $1.8 billion and filed for bankruptcy in March. Sellers of credit-default swaps on Sino-Forest Corp. bonds will have to pay 71 cents on the dollar to settle contracts, following an auction for the bonds held May 9.

Carnes says questions about the accuracy of Silvercorp’s filings to China’s State Administration for Industry & Commerce began to emerge in the first half of last year, prompting Carnes, Block and other short sellers to separately undertake due diligence. On Sept. 2, Silvercorp fell 9.7 percent in Toronto after it said in a statement it was aware of an anonymous letter dated Aug. 29 alleging irregularities. Silvercorp denied the allegations, which are summarized in the statement.

‘At Risk’

Carnes says he was so disappointed with the Silvercorp response to the letter that he decided to publish his own research on Sept. 13. Later that day, Block posted on Twitter that he was shorting Silvercorp.

“I had no clue that Carson was going to tweet that he was short, and when he did the bottom fell out of it,” said Carnes, who says he pocketed $1 million that day.

In total, Carnes says he and the contributors to what he calls his investment partnership have made about $10 million from shorting Chinese companies.

Carnes says the reason he published anonymous research was for protection from the companies he targeted. Despite being “obsessive” about security, Carnes says his associates faced threats after they were identified as being part of the operation.

In an affidavit filed in the State Supreme Court of New York in September, Carnes said he was aware of five separate incidents in China in which people with whom he has associated in researching companies were subject to threats or physical violence. Carnes said he heard of the incidents directly from the associates and saw facial bruises from the beatings, according to the affidavit.

Carnes says people liked working for in China and he paid them well.

“The only danger we felt was the danger of being beat up,” he says. “I’m worried about the guys in China. They are all at risk.”

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