Sino-Forest saga: Mud on our face

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By Peter Koven, David Pett and John Greenwood

Four days after taking down Canada’s largest forestry firm, Carson Block finally faced investors and analysts on a conference call last Monday. One caller, who sounded upset, asked a legitimate question: In preparing his infamous report on Sino-Forest Corp., how much time did he spend speaking with the company?

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Mr. Block wasn’t rattled. He calmly said he has spoken with Sino’s investor relations executive for a maximum of two and a half hours, and that she seemed knowledgeable on the company.
If the line had been open to all callers, the gasp would have been deafening as everyone absorbed the same information: This guy wiped out $3-billion of shareholder value from a company he spoke to for a couple of hours. No matter how you break it down, the past nine days have been a debacle for Canada’s capital markets, where an obscure short-seller took down a 19-year-old Canadian forestry giant in a matter of hours.

The fact that Sino-Forest was built and nurtured on Bay Street, and the fact that analysts almost universally loved it, meant nothing. Investors instead put their faith in Mr. Block, a 34-year-old drifter with no fixed address whose brazen report on Sino-Forest is actually missing a page.

In short, the Sino debacle has exposed a major flaw in the financial system.

If Mr. Block turns out to be wrong, then it is shocking that investors took his word above the bankers, analysts and auditors who backed this company for years. It undermines Bay Street institutions and could go down as one of their biggest embarrassments.

If he is correct about Sino-Forest, then it’s armageddon reminiscent of Bre-X. It will take years to figure out how the company was able to raise so much money and fool so many outsiders. Almost nobody will come out of it looking good.

Sino-Forest was one of the darlings on the TSX over the past five years, rising more than 2,000% since 2002 to a peak valuation in excess of $6-billion. Its market value is roughly $1.1-billion today, which is less than the cash on its balance sheet and far less than its debt.

Investors are betting that it is almost worthless, and Sino deserves at least some of the blame. In addition to a general lack of transparency, experts unanimously believe that the company botched its response to the short seller attack.

The report from Muddy Waters LLC went public in the early afternoon of June 2nd, and Sino shares were quickly halted. But the company failed to respond until 10:29 a.m. the next day, more than 21 hours later. When it finally issued its statement denying the allegations, Sino cited a couple of specific inaccuracies in the Muddy Waters report, but did a poor job of countering Mr. Block’s broader theme: namely, that the whole company is a joke.

“I liken something like this to a heart attack,” says Drew Bernstein, chairman of the audit committee at Orient Paper Inc., Muddy Waters’ first target.

“It’s sudden, unexpected. And all the things you do in those opening moments usually dictate the rest of the story. If you get to the hospital quickly and you get the right treatment, you usually fare pretty well. If you languish in indecision, you usually don’t fare well.”

Despite Sino’s poor response to the attack, it is still stunning how quickly the company was abandoned by the investment community that supported it for so long.

Sino raised a staggering $2.9-billion in the last eight years with the help of investment bankers (including TD Securities and Dundee Capital Markets), auditors (Ernst & Young), and analysts (who usually rated it a “buy”). It was a mutually beneficial relationship. “The street was paid a lot of money by these guys,” says Warren Irwin, head of hedge fund company Rosseau Asset Management.

Yet once the Muddy Waters report emerged, analysts who previously loved the company started asking questions about it, putting their targets under review and effectively undermining their prior research. That sent a message to investors that someone named Carson Block knows more than they do.

“I have to believe, if the analysts had all stood up together and said ‘We still think this is a buy and this guy is wrong,’ it wouldn’t have gone down 70%,” says portfolio manager David Baskin.

A couple of analysts did come to Sino’s defence, most notably Dundee’s Richard Kelertas. In a remarkable conference call on Tuesday, he jumped way outside his mandate and accused Mr. Block of committing his own fraud, calling his research “a pile of crap.” If he’s right, he will go down as the hero of the saga. If he’s wrong, he will be remembered like former Nesbitt analyst Egizio Bianchini, who backed Bre-X after the fraud allegations (though it worked out fine for Mr. Bianchini, now vice chair at BMO Capital Markets).

According to experts, investors trusted Mr. Block for two reasons: Sino-Forest’s history of poor transparency that lent credibility to his claims, and the fact that whistle blowers are so often right in these situations. From Enron to Bernie Madoff (famously cited in the first line of Mr. Block’s report), the lone wolf in the wilderness is often correct.

Mr. Block, for his part, has no trouble explaining potential cracks in the financial system. He describes the capital markets as a “hot potato” where the various groups (auditors, bankers, lawyers, etc.) pass the blame to each other when the system suddenly fails. “The gatekeepers whom investors think are providing protection against fraudulent listings don’t function as they should,” he says.

That is particularly true for a company whose assets are all in China, which makes it very tough to regulate, he adds. “Everybody seems to have taken the company at its word because it had been public for so long, even though the model it uses has so much potential for abuse.”

While the Sino controversy is bad news for the analysts and bankers, it also raises a broader question about Canada’s capital markets: given that it is essentially a Chinese company, why is it here in Canada in the first place?

One answer is that the Toronto Stock Exchange is the best place for start-up resource firms to raise money, regardless of where they operate. It is full of companies that maintain a shell office in Canada but are otherwise not remotely “Canadian”. Some of them, notably First Quantum Minerals Ltd, became huge successes this way. No other exchange is as adept at shining up junior companies and making them irresistible to investors.

Executives with TMX Group Inc. have spent years criss-crossing the Globe to encourage more foreign firms to list on the TSX. And in China in particular, they have had a lot of recent success. Of the 52 current Chinese listings on the TSX and TSX Venture, only five have been listed for more than a decade, and the majority in the past five years. These firms are now under much more scrutiny, particularly those like Sino that arrived to the public markets via reverse takeover (or RTO).

With an RTO, companies don’t have to provide their core disclosure until after the main financing has been completed, according to a recent paper published by CIRANO, a Montreal public policy firm. The bottom line is that reverse takeovers “create a situation with massive asymmetric information, risk and uncertainty,” says the paper.

Ermanno Pascutto, executive director of investor advocacy group FAIR Canada, believes there is growing concern not just about RTO-listed Chinese companies but all emerging-market companies on North American exchanges.

“In terms of the integrity of our markets and confidence of institutional and retail investors, I think someone really needs to do a risk assessment as to whether these types of listings contribute to our markets or whether they are detrimental to them,” he says. He adds that the Hong Kong Stock Exchange has much stricter listing requirements, and is concerned that high-risk Chinese companies could damage its reputation.

Like many others, he wonders how Canadian regulators can possibly keep track of these companies as well as the ones here at home. It is a question the Ontario Stock Exchange will be asking itself as it investigates the Sino saga in the weeks to come.

However the story plays out, a major lesson has been learned: that in the social media era, where information is passed around as quickly as someone can tweet it, there is nothing to stop an obscure short seller attack from creating chaos in a matter of minutes. Carson Block showed how it is done, and market participants fully expect it to happen again.

“It’s the new world we live in. The mainline information sources are long gone. Now it’s the blogs, it’s Twitter, it’s comments after articles online. All of that is part of the milieu now,” says a senior capital markets executive.

Experts have no advice for investors except to be prepared for such attacks, absorb the information as best as possible and act accordingly.