Sino-forest sells off... potentially the biggest Chinese RTO scandal... and one of the biggest in Canada

NOTE: Do not construe anything written below as implying that Sino-forest is a fraud. I'm simply repeating some who are presenting information that casts doubt on Chinese RTOs, including Sino-forest. Their opinions may or may not be correct. Future of stock price movements cannot be predicted with certainty.

As I and others have mentioned, it appears that a big number of Chinese RTOs (reverse-take-overs) are dubious and in some cases, outright scams. So far, most of these have been micro-caps and small-caps. However, one of the bearish research firms, Muddy Waters Research, has tackled a bigger company, Sino-forest (TSX: TRE), whose market cap before the recent sell-off was around C$3 billion. Sino-forest is a forestry company listed on the Toronto Stock Exchange—it was actually a darling of some commodity investors a few years back—with operations largely in China, with some marginal stake in New Zealand.

A few days ago, Muddy Waters Research published an extremely bearish 19-page report on Sino-forest. Saying 'extremely bearish' probably underplays the report since the analyst suggest Sino-forest's shares are worth less than $1 versus the $18+ the shares were trading for before the report came out. The shares promptly collapsed over 70% this week on Muddy Waters opinion and other market events (including the sell-off in the broad markets):

The Globe & Mail has a story summarizing the key details that are available on this story.

Although I have been keeping an eye on the Chinese RTO scandal, I have little interest since I don't invest in those companies. I decided to spend some time writing about Sino-forest because, if accusations turn out to be true, it may end up being one of the biggest stock market scandals in Canadian history. Since this is a natural resource company, it may also be a minor bearish event for Canadian commodity stocks (even though they don't have anything to do with China in the manner of Sino-forest). Until accusations are refuted, it is hard to say who is right on this issue.

The Accusation

Why does Muddy Waters say Sino-forest should be worth less than $1/share?

From the report I linked above, Muddy Waters says:
The foundation of TRE’s fraud is its convoluted structure
whereby it runs most of its revenues through “authorized
intermediaries” (“AI”). AIs supposedly process TRE’s tax
payments, which ensures that TRE leaves its auditors far
less of a paper trail.

On the other side of its books, TRE massively exaggerates
its assets. We present smoking gun evidence that TRE
overstated its Yunnan timber investments by approximately
$900 million.

TRE relies on Jakko Poyry to produce reports that give it
legitimacy. TRE provides fraudulent data to Poyry, which
produces reports that do nothing to ensure that TRE is

TRE’s capital raising is a multi-billion dollar ponzi scheme,
and accompanied by substantial theft.
Muddy Waters has done on-the-ground investigation and claims that the whole company is a fraud. The following diagram from their report suggests how the authorized intermediaries (AI) are used to mask the activities of Sino-forest (TRE).

Sort of reminds me of Enron and its special purpose entities that was used to mask reality. Having said that, I'm not an expert on Chinese corporations or accounting in general, and it's possible that Sino-forest is minimizing tax liabilities and not necessarily trying to fake their numbers to their shareholders. Many Chinese companies are rumoured to mask corporate transactions to avoid paying taxes so it's hard to say based on a quick look of Muddy Waters' report. Overall, though, Muddy Waters does seem to present a bearish case for Sino-forest shares.

Muddy Waters and Carson Block

I don't know much about the veracity of Muddy Waters. Some of the players, the investors, the analysts, the media and PR/IR spokespeople in the whole Chinese RTO debacle seem to be shady characters that are hard to trust. Many of them, including some of the bearish research analysts appear to have a tangled web of past (minor) criminal history (like some of the key contributors at ZeroHedge, the underground investment blog). Yet, unlike many others who hide behind anonymity, Muddy Waters' principal, Carson Block, has at least been publicly forthcoming. There have been several stories about him in recent months, including this one from Barron's.

Muddy Waters is an unusual research firm in that it actually takes short or long—mostly short it seems—positions in stocks it provides an opinion on. Most Wall Street firms have a Chinese wall between research analysts and others who invest and own shares in covered firms (some skeptics claim this wall has holes but I'm not going to go into that here; I do think mainstream Wall Street firms try to keep the two separate). So, Muddy Waters, unlike mainstream research firms, can actually bet against the shares of a company and then release a bearish report. So, everyone should keep this in mind—this isn't just any old, conventional, research firm.

How does Carson Block view Chinese RTOs? Here he is on CNBC from April:

An interesting comment by Carson Block is that many of these dubious Chinese RTO stocks aren't doing overtly illegal actions in China. He suggests that these companies are keeping their noses clean and staying under the radar in China (he says around the 2:40 mark in the video above). I find this amazing because my cursory look (of others' opinions and publicly available research) for some potential frauds appear to indicate that the whole business is a scam—mostly empty shells or companies that aren't carrying out any business (or appreciable amount of business). So, many of these appear to be financial frauds while the physical (non-existent) business is represented "legally"(?) in China. In other words, in one jurisdiction—the one where they are located and operate—they appear to be clean, while it is a complete fraud in another—the one that is used to finance the company. It remains to be seen what materializes if any shareholder lawsuits are launched against some of these frauds.

I also wonder if these frauds are indicative of the old joke that Chinese companies keep three accounting books: one for the public, one for the tax authority, and one that is the real one. Maybe investors as the joke would have it, have been seeing the first one so far.


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