As they toured a Louisiana sawmill late last week, a group of Bay Street analysts began to feel their BlackBerrys vibrate with urgent messages from back home.
Something strange was up with Sino-Forest Corp., TRE-T a fast-growing forestry company that owns trees in mainland China, is managed out of Hong Kong but has been listed on the Toronto Stock Exchange since the mid-1990s. Every one of the Canadian analysts had been positive on the company's prospects; each one recommended owning the shares. But the stock was now in freefall, and confused traders and clients wanted to know why.
Soon enough, they got an answer. A research analyst, Carson Block, had published a report full of sensational allegations, in the most inflammatory language possible. Sino-Forest, he wrote, was a “fraud” that had raised piles of money from investors in a “multibillion-dollar Ponzi scheme.” More specifically, he claimed that Sino-Forest had inflated the value of its timber holdings and produced fictitious revenue.
That Mr. Block was previously an unknown – and was short-selling Sino-Forest stock in an attempt to profit from its fall – seemed to matter little to the market: over the course of two days, investors knocked more than $3-billion, or 71 per cent, off the company's value. The company denies all the allegations.
More than a week later, a few things have become clear. First, there were problems with Mr. Block's analysis. Second, serious questions still remain about Sino-Forest's business, its accounting and its assets – questions that the company has set up an independent committee to resolve. And third: if there is any substance to the allegations about Sino-Forest, Bay Street analysts failed to sniff out the problems. Before the Block report, seven out of seven Canadian-based analysts rated the shares a buy.
It will likely be weeks, perhaps months, before investors hear the truth of the matter. But the furor caused by Mr. Block's report is also causing new scrutiny of the work that analysts do at investment dealers, and raising questions about the obstacles they face when covering Chinese public companies, even those listed on Canadian and U.S. stock exchanges.
Not only is there a distance barrier, but there are also language and culture divides that make it much harder to track the companies they have been assigned. Yet investment banks encourage their analysts to cover these companies like Sino-Forest because they cross the Pacific to tap the pockets of North American investors. To do that, they need to hire investment banks, and these contracts pay big equity and debt underwriting fees.
Sino-Forest has raised more than $2-billion in equity and debt since 2007. To compete for a piece of that business, investment banks normally have to employ an analyst to cover the company. Nearly all the investment banks whose research departments cover it have played a role of arranging the company's financing. Credit Suisse Securities Canada and Dundee Securities have been the two most-favoured dealers, and TD Securities has also been a prominent player. On the equity deals alone, the underwriters have been paid more than $35-million in fees.
The report by Mr. Block's firm, Muddy Waters LLC, has forced analysts to stake out a position. Aside from Richard Kelertas at Dundee Securities, who called the Muddy Waters report a “pile of crap,” the analysts have mostly stayed mum and simply put the stock under review. On Friday, Paul Quinn at RBC Dominion Securities noted that there is “evidence mounting in Sino's favour.”
But no one has yet been able to verify Sino-Forest's Chinese contracts, or knows if they can be relied on.
In the wake of the collapse of Bre-X Minerals and numerous dot-com darlings more than a decade ago, Claude Lamoureux, former head of the Ontario Teachers' Pension Plan, was a part of a committee that studied the standards that apply to analysts and came up with reforms for the system. But the industry, he says, including both analysts and auditors, still do not have to take enough responsibility for their work.
