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Jon Carnes (right) and his researcher Kun Huang, who ended up in Chinese prison for investigating Silvercorp. Dina Goldstein for Report on Business magazine

On May 14, the British Columbia Securities Commission dismissed fraud allegations against Jon Carnes. The allegations arose from Carnes's publishing a negative report about Silvercorp Metals Inc. and profiting from a short position he held in Silvercorp shares. Here is the full story of the Carnes case, from the June issue of Report on Business magazine.

The hearing room in the 12th-floor offices of the British Columbia Securities Commission (BCSC) offers a gob-smacking view of Vancouver’s bustling harbour. But on the morning of last Nov. 28, the scenery was the furthest thing from the minds of those who’d gathered there to hear testimony. On this day, a lawyer for the commission, Derek Chapman, was interrogating a hedge fund manager.

“Your name is Jon Richard Carnes?” Chapman asked.

“Correct.”

“Your legal name has never been Alfred Little?” queried Chapman.

“Oh, no.”

“So you didn’t have 35 years of investing experience?”

“No.”

“You didn’t begin your career as an accountant at Deloitte?”

“No.”

“You didn’t spend 10 years in China from 1994 to 2004 representing various foreign investors, including Coke… Procter & Gamble and Budweiser?”

“No.”

Jon Carnes, whom Chapman was grilling, is manager of a hedge fund called Eos Holdings LLC. The BCSC alleged that Carnes, 41, had committed fraud, accusing him of publishing erroneous reports about Silvercorp Metals Inc., a Vancouver-based mining company. The reports wiped out about $275-million worth of shareholders’ value in a single day back in the summer of 2011. Carnes profited from the decline to the tune of $2.8 million by shorting Silvercorp’s stock (all currency in U.S. dollars unless otherwise noted).

The case against Carnes, whose resolution was pending at press time, included allegations that he’d invented a fake investor, Alfred Little, and anonymously posted his criticisms about Silvercorp on an eponymous website. Hiding behind Alfred Little, Carnes questioned the quality and quantity of minerals coming out of Silvercorp’s silver, lead and zinc mines in China.

Still, some wondered if the BCSC was pursuing the wrong party. “It’s totally outrageous,” says Robin Haller, a principal of Zachary Capital Management, a London, U.K.-based investment firm, who has investigated Silvercorp himself. “How can you have an efficient market without people having the right to question companies? And

Carnes has a great track record.”

Carnes, seen in a Great Wall snapshot below, went to China to make money—but fell in love with the country

Jon Carnes shatters the image of hedge fund managers as macho privateers storming the citadels of high finance. Introverted, a little obsessive, he comes off as nerdy. He remembers being annoyed after accepting an invitation to attend the Super Bowl as a guest of E*Trade. “I was the kind of guy who would rather miss the Super Bowl so I could keep trading,” he says with a laugh.

Born in Lancaster, South Carolina, Carnes initially planned to attend medical school. But after taking an economics course, he decided to become a trader. Starting with $3,000, he made his first million three years after leaving university. By 1999, Carnes was such a big client of E*Trade that the company put him in their TV commercials. That same year, he turned down a job at Goldman Sachs, preferring to work on his own. He became a value investor and began consulting for Andrew Worden, CEO of Barron Partners LP, a Wall Street investment fund. “[Worden] taught me how to conduct due diligence on companies,” Carnes says.

By 2004, Carnes had moved to Vancouver, the better to take advantage of investment opportunities in China. He set up his own investment firm, Eos Holdings, and began recruiting Chinese students at the University of British Columbia. The idea was to train them in due diligence and send them to China to research companies. He and Barron would then invest in the best finds. That’s how Carnes found UBC finance and accounting student Kun Huang. “He was the best one,” says Carnes. “He was the smartest.”

The soft-spoken Huang was born in China’s Hubei province. His family immigrated to Vancouver in the mid-’90s. By 2006, Huang and Carnes had moved to China, eventually setting up their base in Chengdu, the capital of Sichuan province in the middle of the country. Huang’s job was to oversee a team of six researchers. “I liked China and the Chinese people,” says Carnes, who married a Chinese woman; they have two children.

The arrival of the two men in China dovetailed with the appearance of hundreds of Chinese companies on the North American capital markets via reverse takeovers. In an RTO, a shell company is purchased as a quick and dirty way of listing on a stock market. “We were the dummies who invested in RTOs,” chortles Carnes. Eventually it became apparent many of the Chinese RTOs were frauds in part or in whole. “Our perception began to change 180 degrees,” says Carnes. The strategy of investing in China didn’t seem so sharp after all.

By 2009, Carnes had arrived at a simple solution—short selling. Shorting involves borrowing stock in a company at a certain price and selling it, betting the stock will fall. If all goes according to plan, the short then buys the stock at a lower price, replaces the stock in the lender’s inventory and earns a profit on the difference. If Carnes could find Chinese companies that had oversold themselves, he could profit by exposing their sins, which would drive down the stock. Carnes created a website called “worthlesspennies.com” and began posting critical reports on companies his team uncovered.

This strategy came with a price. Chinese companies didn’t take kindly to criticism; some responded with force. In 2010, after he published a critical report on China Natural Gas, Carnes says the company’s chairman sent someone to his office to threaten him. “It was scary because they had the power to kill you if they wanted to,” he remarks.

Carnes decided to adopt more elaborate security measures. “We spent time devising a cover plan,” he says. “We created this old dude who clearly did not look like me.” Thus was born “Alfred Little,” a former Deloitte accountant with 35 years of investing experience. Carnes also created a fake research organization, the International Financial Research & Analysis Group (IFRA). In his “undercover strategy,” IFRA would prepare due diligence reports, which would then be “leaked” to Alfred Little, who posted them on his website. In reality, everything was generated by Carnes and his team. “The guys in China would be trying to figure out who was this old guy,” he says.

For a time, it worked: Carnes’s researchers dug into a host of Chinese companies trading on the North American markets, such as Deer Consumer Products, Rino International, China Integrated Energy, Sino Clean Energy, Puda Coal and others. All ended up in the ditch: The first four were de-listed from Nasdaq, while Puda was delisted from what is now NYSE MKT and its chairman charged by the Securities and Exchange Commission with securities fraud.

But by 2011, the landscape was changing—and not to the short sellers’ benefit. The first seismic event occurred in June of that year, when a short-selling firm, Muddy Waters LLC, exposed Sino-Forest Corp., the largest timber company listed on the Toronto Stock Exchange, as a possible fraud. This scandal put the Chinese government on notice that short sellers could seriously tarnish the image of China Inc.

In May of that year, Carnes received an anonymous tip about a Vancouver-based mining company called Silvercorp.

Silvercorp is the brainchild of Rui Feng, an ambitious and hard-charging geologist who was born in China and raised in a military camp while his father served in the People’s Liberation Army. Feng did his PhD at the University of Saskatchewan before working as a research scientist in Calgary. He then went into mining.

Silvercorp landed on the TSX via a shell company called SKN Resources Ltd. (although Feng says the arrangement was not an RTO, it bears the earmarks of that approach). Silvercorp entered China in 2003 and began buying up silver, zinc and lead mines in the northeastern province of Henan.

The company’s prize asset is the Ying silver mine, which is responsible for the bulk of revenues. Silvercorp runs the mine through a company it controls called Henan Found, which is a joint venture with a state-backed enterprise.

The Ying area had been mined for a long time, but with new investment and mining techniques, Silvercorp soon claimed it had become the “largest primary silver producer” in China. By 2006, it was releasing glowing reports that the grade was as high as 1,535 grams per tonne, on par with the richest silver mines in the world. That same year, Silvercorp raised $47.8 million (Canadian) in a bought deal with Bay Street firms Sprott Securities Inc. and GMP Securities LP.

By 2011, when Carnes received the tip about Silvercorp, its market cap was around $2 billion; it had sales of $167 million. Its shares were trading on the TSX and NYSE in the $10-$12 range, and it was earning net profits of $69 million. “After Sino-Forest happened, we began to look at a list of all Canadian-listed Chinese companies,” says Carnes. “When I asked around [in China] about Silvercorp, everyone said it had red flags.” Carnes says that Henan government officials said the Ying mine was less rich, and was being depleted faster, than Silvercorp claimed. Led by Huang, the Eos researchers began compiling data on the company.

Carnes could increase his profit from shorting the stock if he found evidence that Silvercorp was misleading North American investors. He focused on whether its mines were truly as bountiful as the company touted in technical reports. His staff began putting out feelers to find a mining consultant to help them, eventually deciding to use a report by John-Mark Staude, a Harvard-educated, B.C.-based geologist.

While Staude said the doubts over ore and production numbers could possibly be explained by different reporting methods used in China and North America, he did find things that worried him. For one, resource estimates for the Ying mine were being provided by Silvercorp employees and not by independent geologists (this is acceptable to regulators, although it’s considered less than transparent). Staude noted that Silvercorp’s approach of buying small mines and operating them efficiently “does not scale to a billion-dollar company often or easily.” He added, “The [Ying] mine has calculated reserves that are only 68 million ounces of silver equivalent. This is worrisome for a $100-million market cap company, let alone a $1-billion market cap company. They should have more resources.” In one e-mail Staude wrote, “Chinese documents show the mines are almost depleted!!! Very different in Chinese documents than what the Corp. presentations say.”

Carnes was not the only short seller poking into Silvercorp—others included Anthion Management LLC, Valiant Capital and Muddy Waters. By September, 2011, at least four reports from Carnes’s competitors were circulating in the investment community and beyond, all accusing the company of a bevy of misdeeds. Carnes had taken a $4.1-million short position when the company’s stock was trading at around $9.

On Sept. 13, Carnes released an eight-page report on the Alfred Little website entitled “Questionable Customers, Geologists, Production, Quality and Serious Related Party Failures.” His most compelling charge was that while Silvercorp told investors it had produced 316,522 tonnes of ore in 2010, the Henan resource bureau (which receives data on local mines) said it had produced only 207,037 tonnes. And while Silvercorp said it produced about 131 tonnes of silver that year, it reported only 32 tonnes to the bureau—a discrepancy of 75%. He also said that while the company was claiming a silver grade of 774 grams per tonne in 2010 and 845 grams per tonne in 2009, the resource bureau said the figures were actually 155 grams and 213 grams, respectively. It looked like Sino-Forest all over again.

Carnes cherry-picked from Staude’s reports, without naming the geologist, suggesting the value in the mines did not come close to supporting Silvercorp’s market cap. Staude’s more positive comments were omitted.

The impact on the stock was dramatic—it fell 20% on the day the report came out. Carnes cashed in his short position and pocketed $2.8 million.

Carnes (centre) and his team of researchers at the Chengdu Hooters in 2010

Silvercorp and Feng immediately came out swinging. Feng called the short sellers’ reports “short and distort” attacks and likened them to bullies who use “false, selective, ignorant statements and rumours.” He said: “I never cheated nobody” and “they picked the wrong company” and “I am going to fight to the death.” The company announced the striking of a special committee and hired KPMG to investigate the claims of the shorts, against whom Silvercorp also launched a defamation lawsuit.

Silvercorp issued a detailed press release saying the differences between its North American filings and the Henan resource bureau data was explainable: The Chinese numbers, it said, were out of date and didn’t include recent discoveries. The company also said its profit and revenue figures matched up perfectly with Chinese tax records. This PR campaign worked: The stock rebounded to more than $9 by the end of October, earning back more than what was lost in the wake of Carnes’s report.

Around the same time, both Silvercorp and Carnes contacted the BCSC to complain about the other party. The BCSC opened two investigations: one into Silvercorp, the other into Carnes.

It was only last year, after a legal battle, that Carnes’s lawyers got some insight into the BCSC investigation of Silvercorp. The lawyers pried loose a letter that the commission’s chief mining adviser, Robert Holland, sent to Rui Feng in November, 2011. The eight-page letter was a litany of complaints about Silvercorp technical reports. Holland wrote that the reports used resource estimation methods that were inconsistent with best practices, and contained “errors that could individually or collectively result in material overestimation of mineral resources.” Holland pointed to one technical report that, he said, relied “unduly” on information from the company’s chief operating officer and president, and had “uncorrected errors in mineral resource tables.” He added that there were large unexplained differences in the report between two measures of a mine: resources and reserves. In summary, he wrote: “We consider the Company to be in material default of its technical disclosure and filing requirements.” He threatened to put Silvercorp on the BCSC’s default list—exposed publicly as a company that was in violation of the BCSC’s rules.

It’s not clear how Silvercorp responded to this and other letters from the BCSC. But it appears the commission’s investigation into the company was eventually dropped—the BCSC itself won’t say—after Silvercorp decided to hire a bigger mining engineering firm to produce its technical reports.

The inquiry into Carnes, on the other hand, went ahead. “It’s very clear that the BCSC didn’t want another Sino-Forest,” muses Carnes. “So to prevent that, [they] really scrutinized the short sellers while working with the companies to re-solve any real issues.”

Back in China, Silvercorp had one major thing working in its favour—the support of China’s government, which was tired of short sellers badmouthing Chinese companies.

Carnes says that in November, 2011, while he was on vacation outside of China, “I got word that the police were chasing us.” He decided against returning to China. Kun Huang and his researchers were not as lucky. They were rounded up one by one—three were arrested and soon released, while three others were questioned. Huang wanted to leave the country but was held up waiting for his passport to be returned to him. When he tried to fly out of the Beijing airport at the end of December, he was grabbed. “I was thrown into a place with 20 guys in a freaking tiny cell,” he says.

After three days at a detention centre, Huang was driven by police to Luoyang, near Silvercorp’s mines. For the next month, Huang was interrogated frequently by the Luoyang police, who asked him about Carnes and his operation. He also noticed something curious: For the first few days, the police were receiving texts and phone calls before and during these sessions. “I have a strong suspicion it was someone from [Silvercorp],” he says. The police also seized his laptop.

In 2012, a Globe and Mail investigation revealed that Silvercorp helped pay for police expenses in the investigation of Carnes’s operation. Evidence also shows that Silvercorp passed results of the Chinese police investigation to the BCSC.

In a series of e-mails, Lorne Waldman, Silvercorp’s then-corporate secretary (he is now senior vice-president), forwarded details of what Huang was telling police to two BCSC staffers investigating Carnes, Liz Chan and Michael Pesunti. “Luoyang police have indicated to Silvercorp that they will have all details of the questioning translated and that they will share everything with the RCMP and FBI,” wrote Waldman to Chan and Pesunti on Dec. 30, 2011, two days after Huang’s detention. At one point, Silvercorp provided the BCSC with a three-inch binder of material from their investigations into Carnes and his staff. “I will courier the binder to you today,” Waldman wrote to Pesunti. “After you have the chance to review the materials, I would also be happy to arrange a time to meet with you in person to discuss the materials.”

Other evidence indicates Silvercorp obtained private information from Huang’s laptop, which the firm used in a court proceeding. In a 2012 court motion in New York, the company sought to gain access to Royal Bank of Canada accounts to obtain the short sellers’ trading information. Silvercorp provided a list of phone numbers, which they wanted to match with trading accounts.

Carnes realized the numbers came from a copy of his personal address book that Huang had on his computer. The giveaway, apart from the faithful replication of typographical errors, was that his wife’s frequent-flier account number had been misconstrued as a phone number. “They immediately dropped [the application] as soon as we said this seemed to have been taken from Kun’s laptop,” says Carnes.

Huang, though, was in limbo. His Canadian passport had been taken away from him, and he was forced to remain under house arrest.

Had Silvercorp misled investors about the quality of its mines?

Up until 2011, the company had relied on a two-man consulting firm whose technical reports were based on resource estimates Silvercorp had provided to them, and who hadn’t visited the Ying site since 2008.

The firm that Silvercorp hired after pressure from the BCSC and other sources was AMC Mining Consultants (Canada) Ltd., a heavyweight consulting firm. In the spring of 2012, it produced a lengthy technical report for Silvercorp, which the company said vindicated its position that it had misled no one and its mines were viable. Others saw it differently.

Mohan Srivastava, a Toronto-based, MIT-educated mining geologist, was hired as an expert by the lawyers suing Silvercorp on behalf of Canadian shareholders. Srivastava examined the company’s publicly released mining records and, in affidavits filed in court, said the average grade of the Ying mine’s silver resources had dropped every time they were updated and reported: from a high of 1,535 grams per tonne in 2006 to 425 by 2011. (More recently, it was less than 300 grams.) “The silver grade…now stands at less than one-third of what [Silvercorp] reported when production began,” he wrote. “These decreases cannot be accounted for by production depletion.”

Srivastava also found the company did not state the mine’s reserves (that is, the quantity of ore that is economically and technically feasible to mine) until it was already five years into production, which he called “highly unusual.” And its production forecasts had always been too optimistic—for example, in 2010, it said it would mine 240,000 tonnes of ore at 509 grams of silver per tonne, when in fact it mined 386,000 at a grade of 408. This suggested that Silvercorp was digging far more ore at a lower grade than they were forecasting to investors.

Srivastava also zeroed in on the September, 2011, press release issued by the company in response to Carnes’s damning report. It posted the production and ore grades for 2009 and 2010 and declared that they matched the company’s Chinese tax filings; therefore, nothing was amiss. Yet the report from AMC Mining Consultants posted numbers for these two years that were completely different—with higher ore tonnage and lower grades, meaning a less profitable mine. “This is not a case of a discrepancy between production reality and forward-looking predictions of what the mine should be able to produce,” noted Srivastava. “It is a case of numbers presented as production reality being significantly wrong. It is a misstatement of a past fact.”

Such issues ultimately made the Securities and Exchange Commission suspicious. In 2013, it subpoenaed all documents regarding Silvercorp’s battle with the short sellers and sent letters to the company asking for clarifications, in particular as to why the production and grade numbers did not match their technical reports.

As a result, Silvercorp admitted to the SEC that its figures had omitted Direct Shipping Ore. DSO is rock that contains mineral in very high concentrations—as much as 10 times more than average. In the case of the Ying mines, this ore is hand-picked off conveyor belts and then sent directly to a smelter. One estimate suggests that more than 20% of silver production from the Ying mine is derived from DSO, and its value could be as much as $60 million a year—coming to more than $400 million since the mine went into production. Yet the company’s technical reports gave few details about the DSO and don’t mention it at all between 2010 and 2013. Even the name of the smelter where the DSO is processed is not reported. “They have basically admitted their historical grades and historical production numbers were false,” says Carnes. “Was it intentionally false? I think so.”

Until Silvercorp deigns to reveal more details, what happened to the DSO, and who profited from it, is a mystery. Business can be murky in China. Silvercorp revealed in 2013 that a fraud happened at the Ying mine earlier that year: Contract miners, who were paid by the tonne of rocks they dug out, mixed in refuse to get more pay.

Despite all the strange behaviour, it appears the BCSC has not renewed its inquiry into Silvercorp (again, the commission will not comment on this). Instead, it alleged Carnes had committed fraud in 2013, claiming he’d misled Silvercorp investors about who he was—specifically over the fake persona and credentials of Alfred Little—and by cherry-picking the conclusions of John-Mark Staude to make his take sound worse than it really was. The BCSC did not pursue any other short sellers, who, being based outside the province, were outside its jurisdiction.

The only witness the commission called last fall during five days of hearings was its own investigator, Michael Pesunti. When cross-examined by Carnes’s lawyer, Pesunti admitted the BCSC knew of no action taken against Carnes by Silvercorp’s investors, that the commission spoke to no investors, and that he was aware Silvercorp was receiving information from the Luoyang police about Huang and passing it on to himself. Pesunti also admitted he’d received information from Huang’s laptop, and that he did not ask Silvercorp about various allegations the short sellers raised about the company. (He did, however, refer a small proportion of the concerns to another branch of the BCSC.)

Today, Silvercorp refuses to answer any questions, except to point to the BCSC evidence against Carnes. Meanwhile, the company has suffered setbacks. In 2012, the defamation lawsuit Silvercorp had launched against Carnes and other short sellers was thrown out by the New York Supreme Court on the grounds that the shorts were within their rights to publish opinions about Silvercorp. Then, last fall, the company shelled out $14 million to settle an American shareholders’ lawsuit over allegations of fraud, without admitting any wrongdoing. The company is facing a similar shareholders’ lawsuit in Canada. Huang, too, is suing Silvercorp for its involvement in his incarceration in China. According to a submission to the BCSC by Carnes’s lawyer, the RCMP opened an investigation to see if the company corrupted foreign officials; the RCMP will not comment.

Silvercorp is struggling financially, too: Sales fell to $108 million in fiscal 2014 (from $181.6 million in 2013), and it rang up a net loss of $48.4 million—mostly due to silver prices dropping and the payment of a large Chinese tax bill. The stock was trading as low as $1.13 in recent months, underperforming other silver producers. Meanwhile, after stepping down as CEO in 2013, Rui Feng reclaimed the post this past December.

Traumatized by his time in a Chinese prison, Kun Huang is angered by the actions of B.C.’s securities regulator on the Silvercorp file

The price Kun Huang paid in the Silvercorp affair was steep. Meeting in his lawyer’s office, Huang is a slim, neatly dressed, contained 37-year-old. After he was placed under house arrest in Luoyang in 2012, Huang hoped all would blow over. But after an article in The New York Times criticized Silvercorp that summer, he was rearrested.

Huang was placed in a 300-square-foot cell with 30 other inmates, most of whom were street criminals. “For the first few months, I had to sleep on the floor because there was no room on the beds,” he relates. “It was really dirty and filthy.” He says the food consisted of old bread and broth made from flour and water. “I couldn’t eat for the first few weeks because it was not food,” he recalls. He lost 40 pounds. He could receive no visitors, except his lawyer and the occasional Canadian foreign affairs official.

Finally, in the summer of 2013, Huang was charged with “criminal defamation” for criticizing a Chinese company. His trial in September of that year lasted one day and was closed to the public, at Silvercorp’s behest. Silvercorp was also granted standing.

In the end, Huang received a two-year sentence and was returned to the same overcrowded cell to serve out the rest of his term. He was released last summer and flew back to Canada. Today he says he suffers from post-traumatic stress disorder, is afflicted with nightmares and flashbacks, and sees a psychologist. “I sometimes get depressed a lot and I have a short temper now,” he says. “I get agitated so easily.”

He’s particularly angry with the BCSC. “The commission does not look out for investors and for people who are treated unlawfully by this company,” he says. “I think [the BCSC] is trying to protect B.C. companies....They want to protect their image.”

Carnes continues to investigate Chinese companies—and he has been using his own name on his reports since 2012. Most recently, he went after FAB Universal Corp., a Chinese media distribution company that apparently has gone out of business after being delisted from NYSE MKT.

In a 2014 survey by Activist Shorts Research that ranked short sellers according to returns from their campaigns, Alfred Little ranked first out of a field of 28.

Yet any profits Carnes made from shorting Silvercorp have long been eaten up by lawyers’ fees and related costs. He recalls that when he was working in China, he and Huang always worried one of their targets would turn into “a nightmare disaster.”

“We didn’t think it would be Silvercorp, though,” he concedes. It was, after all, a company run by Canadians.

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