A sensational set of allegations against Sino-Forest Corp. sent the shares of Canada's largest publicly traded forestry company into freefall, prompting regulators to halt trading while investors waited for the company to say something in its defence.
The 21-per-cent plunge, which cut nearly $1-billion off Sino-Forest's market value, was touched off by a report by an obscure U.S. firm called Muddy Waters Research. The document alleges that Sino-Forest inflates its revenues and evades scrutiny by operating under such a complex structure that it is almost impossible to trace how cash is moving through the company.
The report's author, Carson Block, alleged that Sino-Forest "massively exaggerates" its assets, "has always been a fraud" and that it "falsifies its investments" in trees. The report quickly made its way through financial circles in Canada and the U.S. South of the border, where Sino-Forest's shares trade over-the-counter, trading was not halted, allowing them to fall all the way to $7.33 (U.S.), a 61-per-cent drop for the day.
Sino-Forest, which is based in Hong Kong but has its primary listing on the Toronto Stock Exchange, owns and manages tree plantations in China and has been a favourite among some investors for its high growth rate and its exposure to the growing Chinese resource sector. The company did not return calls requesting comment and, as of Thursday evening, had not provided a statement to the market about the allegations.
However, Bloomberg News reported late Thursday night that the company has set up a special committee to deal with accusations it overstated its timberland holdings and production. The news service cited Charlotte Cheung, assistant manager of investor relations in the company's office in Hong Kong. She declined to comment on the accusations but told Bloomberg the company will issue a statement before the market opens in Toronto on Friday morning.
Muddy Waters is a year-old firm founded by Mr. Block, who spent time in China and now runs a company that he says "sees through appearances to a Chinese company's true worth." Mr. Block has made similar allegations about other Chinese firms, including China MediaExpress and Duoyuan Global Water, after which their chief financial officers resigned.
But his firm isn't solely research-oriented. Mr. Block disclosed that he has short-sold Sino-Forest, which means he profits from its fall. A disclosure on Muddy Waters' website says: "You should assume that as of the publication date of any report on this site, Muddy Waters, LLC (possibly along with or through our members, employees, and/or consultants) along with our clients has an investment position in the stock (and/or options of the stock) covered therein, and therefore stands to realize significant gains in the event that the price of the stock increases or declines, as the case may be."
Sino-Forest's largest shareholder is New York-based hedge fund Paulson & Co., which owns 14 per cent of outstanding shares, according to an April proxy filing. That the company is on the opposite side of a short call is ironic because its founder, John Paulson, made huge profits by short-selling the subprime real estate market. Arizona-based Davis Selected Advisers was Sino-Forest's second-largest shareholder with a 13 per cent ownership.
At its annual meeting in Toronto this week, chief financial officer David Horsley delivered a presentation called "Standing Tall" that emphasized Sino-Forest's "culture of accountability." Among the efforts to promote its clean books, Fred Clifford of Ernst & Young - the lead on accounting firm Ernst & Young's audit team for Sino-Forest - was in attendance to answer questions.
Although the company's stock dropped sharply Thursday, it has been trending down for some time. After peaking in late March, the shares have fallen steadily since, now down 43 per cent in Canada from that 2011 high.
On May 25, Sino-Forest issued a news release saying it was not aware of any reason for its share price decline. "We have a 16-year track record of outstanding operating and financial performance and our corporate governance and transparency is of the highest standards," co-founder and chief executive officer Allen Chan in a statement.
Analysts have also defended the company. On May 13, RBC Dominion Securities noted that the falling shares represented a "significant buying opportunity" and Dundee Securities said Sino-Forest was the "remaining class act" among its competitors.
But the company has also had its problems. Last month, Sino-Forest announced that its first-quarter financial results had been delayed and would be announced June 14 after a 30-day extension from the Canadian Securities Administrators. The company said it requested a delay because of its transition to a new set of accounting standards.
Sino-Forest isn't the first Chinese forestry company to come under scrutiny. China Forestry, which was listed in Hong Kong, had falsified logging permits, according to a mid-May report by an independent committee of the company's board.
Cathay Forest, which is worth about $50-million in market capitalization and is listed on the TSX Venture Exchange, also had its stock suspended in late January. The company is now attempting to sort out various issues, including financial investments and forestry certificates for a plantation in China. It has not yet filed 2010 financial results.
Chinese companies trading in North America have come under growing scrutiny from regulators and investors. The U.S. Securities and Exchange Commission began an investigation last year into the use of reverse takeovers, in which a closely held firm becomes public by purchasing a shell company that already trades. The Bloomberg Chinese Reverse Mergers Index of U.S.-listed stocks has retreated more than 40 per cent since November.
Sino-Forest was co-founded by Mr. Chan and Kai Kit Poon. Mr. Chan had worked as a hotel developer in China and was previously a Hong Kong government manager in land development. Mr. Poon, the president, had spent 15 years as an engineer with the Chinese government in the Guangdong Forestry Bureau, the province that borders on Hong Kong.
The company has been listed in Canada since 1995, and as of mid-May about 10 per cent of the company's shares outstanding had been sold short by investors.
The company has a complicated structure. According to its 2010 annual information form, it has 63 subsidiaries. Of these, 41 are registered or incorporated in China, 16 in the British Virgin Islands, two in New Zealand, one in Hong Kong, one in Barbados, one in Bermuda and one in Suriname.
With files from Boyd Erman and Tara Perkins