Days before the collapse of China A-shares trading began
in mid-June, Carson Block, founder of Muddy Waters, a
preeminent short-selling firm focused on Chinese stocks, was on
CNBCs Fast Money program, warning of attempts by
the Chinese government to inflate share prices. Block, a lawyer
with firsthand experience at trying to manage a start-up in
China, said that massive manipulation was under way and
not just on the Shanghai and Shenzhen stock markets.
In Hong Kong, he explained, you have
what we think is in the aggregate probably the greatest pump
and dump in history with the number of companies share
prices likely being manipulated upward in many cases over 500
percent in the past year. Five years ago, Block was on
the case, uncovering dubious accounting in a first attempt to
wager against a Chinese company. Not surprisingly, big money is
paying attention. Muddy Waters, which has to date mostly
invested its own employees money, recently received major
outside investments of capital and is seeking to open a hedge
fund next year.
The white van careened along a narrow, two-lane road deep in
the snow-covered He Bei province, 150 miles southwest of
Beijing. In the back, Carson Block, attorney, entrepreneur and
capitalist adventurer, bumped along at 35 miles an hour on his
way to visit Orient Paper and its upgraded factory, which, the
company claimed, would allow it to sharply increase production
of high-quality cardboard and other paper product lines. Beside
him sat Sean Regan, a manufacturing expert and Asia hand with a
specialty in supply chain management and quality control.
Both Block and Regan lived in Shanghai, graduates of the
University of Southern California who had become close friends
after bonding over USC football. On this blustery day in
January 2010, they were on their way to visit a small, New York
Stock Exchangelisted company, Orient Paper, at the behest
of Blocks father, William Block, who ran his own Los
Angeles investment firm, WAB Capital. The older Block analyzed
microcap companies and, if he liked them, published bullish
research for a clientele of hedge funds and other money
managers. The rub was that WAB got paid by the company
not investors with warrants or restricted stock for the
research and for introducing management to his investor
clients. Some called him a stock promoter.
The previous night, the pair had scoured Orient Papers
U.S. Securities and Exchange Commission filings and grew
skeptical of the companys claims to inventory turnover
that was more than double that of rivals. There were also
improbably high production figures, what looked like inflated
asset values, a revolving door of top customers and a list of
suspect suppliers at least one controlled by Orient
Papers own chairman.
Now, as the van approached the factory, something else
caught their eyes pavement. The road was not suitable
for the volume of output Orient Paper claimed. We figured
they had to ship 100 trucks a day at maximum capacity,
says Block. Sean noticed that the road didnt have
the kind of wear and tear you would expect.
Entering through a pair of battered gates, Block noticed the
paucity of workers or activity. There was a 20-foot-high pile
of used paper outside, wet, which the company had described in
an SEC filing as expensive feedstock for its operations
worth $4.7 million. Regan climbed the mound of scrap paper and
shouted down to Block.
If this is worth $4.7 million, the world is a lot
richer than I thought, he said.
Inside the factory, the rolling machinery was antiquated.
Water dripped onto a table where paper was to be folded. The
air was thick with steam a prescription for disaster in
a plant that was supposed to produce high-quality paper.
Zhenyong Liu, Orient Papers chairman and chief
executive officer, greeted Block and Regan in his office and
led them on a tour through the factory and workshops.
How many tons do you ship? Block recalls asking.
Liu didnt know.
Well, how do you define a good day? Again, Liu
What kind of metrics are you using, then? Liu
shook his head.
In fact, Liu was unable to answer even basic questions.
Rather than the diamond in the rough that Blocks father
was hoping for, Orient Paper seemed a fraud. Liu rushed Block
and Regan through the rest of the tour. This is
amazing, Block recalls thinking. This is a zero.
This is a sure thing.
Block himself at the time was bleeding cash he was
majority owner and manager of a struggling self-storage company
in Shanghai and could ill afford the time and expense of this
trip to He Bei. WAB obviously wouldnt be publishing
anything bullish on Orient Paper. But on the flight back to
Shanghai, Block and Regan discussed publishing a negative
report via e-mail. Perhaps they could short the stock ahead of
time and at least defray some of the cost of the research
$10,000 to $15,000.
Back in Shanghai, the two delved into their due diligence,
calling Orient Papers suppliers, customers and
competitors. Few of the numbers they turned up backed anything
the company claimed. They compared the SEC filings meant for
U.S. investors to information deposited with Chinas State
Administration for Industry and Commerce, or SAIC. The Chinese
numbers were drastically less impressive. Total 2008 net assets
were less than half those in the SEC filings. Block determined
that fiscal 2009 revenue was overstated by about 40 times.
Block and Regan admit to turning paranoid. They worried that
the Chinese mafia rumored to be entangled with fraudulent
companies was on to them. Im looking for
black sedans, Block says. We started talking in
code. He began carrying a heavy Polycom phone handset
with which he could defend himself.
The research report Block and Regan drafted would eventually
total 30 pages filled with every item they considered
suspicious. They stated that Orient Paper had misappropriated
$30 million in capital raised via private placements on
machinery that did not meet the specifications the company
claimed. The report detailed inflated revenue, turnover and
asset figures. We are confident ONP is a fraud, the
report stated. It included more than a dozen photographs
illustrating the decrepit physical plant and linked to videos
of the tour they had taken.
Block waited for an alarm system to be installed in his
Shanghai apartment before publishing. There were other delays:
He needed a good name for his nascent firm to lend it some
credibility. Block recalled a Chinese proverb: Muddy
waters make it easy to catch fish. He incorporated Muddy
Waters in Las Vegas, Nevada.
Then, through an online brokerage, Block and Regan located
some $4,000 worth of put options, most with August expiration
dates, that gave them the right to sell Orient Paper stock at a
strike price of $7.50 versus the $8.50 or so the stock was
trading at. It was hardly a calibrated strategy. I had no
idea what the fk I was doing, admits Block.
Block released the Muddy Waters report at 1:15 a.m. Shanghai
time on June 28, 2010, via an e-mail blast to 75 investors,
mostly people he had met in his earlier days on Wall Street.
There were less than three hours before trading closed in New
York, and Block remained awake long enough to watch the share
price tick down at the end of the day, closing off 10 cents at
$8.35. I wonder if I did that, he said to his wife,
a Vietnamese-American who had spent days formatting and
paginating the report. (Block asked that her name not be
divulged for security reasons.)
The next day, Orient Paper traded at $7.23, down 11 percent.
The research report had gone viral overnight, and the stock
price would fall below $5 before the company responded.
Orient Paper at first denied it was the company Block had
visited and accused him of lying and extortion. But the report
gathered attention: The 21st Century Business Herald,
two weeks later, published an investigative report on the
Muddy Waters research, in an article that was later posted on
Sinafinance.com, a popular website. Block
sold most of the options in mid-July for a profit of about
$6,000, then went into the market a few days later to buy more
a move that backfired, wiping out his profit and then
Nevertheless, the Orient Paper trade catapulted Muddy Waters
to the forefront of a small and contentious short-selling
movement that has racked up a formidable record of unmasking
fraud at U.S.- and Canada-listed Chinese companies
profiting as the shares of target companies crumble. Other
research firms trawling the same pond include Citron Research,
founded by Andrew Left, and Alfredlittle.com, a website run by a
longtime China investor named Jon Carnes.
They are not the only ones who have bet against the
Easts rising tide. Short sellers like Kynikos
Jim Chanos have focused on Chinas bubble economy,
awash in empty real estate and manufacturing capacity. That has
left it to Block and his ilk to probe the underbelly of the
dicey small-cap markets, where dubious accounting and outright
scams flourish. The explosion in China-based fraud isnt
difficult to explain: U.S. and other foreign investors face
restrictions on buying A-shares listed in Shanghai and Shenzhen
and so have scrambled to sink their money into Chinese growth
story stocks, even those of dubious quality. Chinese operators
are happy to furnish them. So many people are being paid
to manage China money right now, says Block.