(Bloomberg) 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.
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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. helped drive that firm’s stock from $13 to almost zero, erasing about $370 million in market value. It wasn’t a fluke.
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. 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. 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 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., 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.”