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Book Excerpt: Muddy Waters’ Carson Block on Short Selling

Five years ago Carson Block set up research firm Muddy Waters to expose corporate frauds like China’s Orient Paper for opportunistic hedge fund managers looking for a good short.

  • Richard Teitelbaum

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 CNBC’s 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 Exchange–listed company, Orient Paper, at the behest of Block’s 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 Paper’s U.S. Securities and Exchange Commission filings — and grew skeptical of the company’s 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 Paper’s 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 didn’t 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 Paper’s 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 didn’t know.

“Well, how do you define a good day?” Again, Liu demurred.

“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 Block’s 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 wouldn’t 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 Paper’s 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 China’s 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. “I’m 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 f—k 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 some.

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 East’s rising tide. Short sellers like Kynikos Associates’ Jim Chanos have focused on China’s 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 isn’t 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.

The preferred medium for the dicey promotions are reverse takeover companies (RTOs in industry argot) — United States- and Canada-listed shell companies with no operating businesses that are bought by China corporations for the purpose of accessing North American capital. After the acquisition, the shell company typically changes its name to reflect that of its new owners and then proceeds to raise money, often via public equity or debt offerings. Orient Paper fit the description.

The degree to which such companies are entwined with China’s political and economic elite is uncertain. Block suspects the worst. “I think it goes to high levels,” he says. “I believe local and national officials and their families have been involved in the U.S.-listed frauds.”

Block believes an organized network originates the frauds, taking the dubious companies and dressing them up for reverse takeovers and eventual listing. He cites an article by Today’s Fortune, an economics newspaper, that alleges a sophisticated “Fraud School” matches sham enterprises with shady auditors who provide expertise on faking financial documents, tax receipts and bank accounts. For the occasional investor performing due diligence, the school furnishes the companies with the phone numbers of fake customers who are given scripted answers to likely questions. If a factory visit is demanded, teams of “workers” are hired for the day and brought to empty factories where production equipment and bogus inventory has been shipped in the day before.

The ill-gotten profits are generated by selling shares to the public and then using the proceeds not channeled directly to management to buy machinery or properties at wildly inflated prices, with the kickbacks being distributed to scam artists.

Orient Paper responded to the Muddy Waters report by flatly denying virtually every negative assertion. The market didn’t buy it. The days and weeks after the Orient Paper research report were a flurry of activity. Muddy Waters issued follow-up reports, and the often-somnolent Chinese news media began to investigate Orient Paper. By early March 2015, Orient Paper traded for 95 cents. Meanwhile, Block found himself in demand.

“I learned that this was the tip of the iceberg,” Block says. “People are e-mailing, calling, Skyping. This company is a fraud, that company is a fraud. It was investors, funds, short sellers.”

Some communications were less welcome. “Bullets to the brain can be quite painless,” read one anonymous e-mail message. A blogger posted Block’s father’s address in Los Angeles — suggesting a group visit by Orient Paper investors.

Though Block ultimately lost money on the deal, he knew he had stumbled on a business opportunity, but he needed to decide how to proceed. “I was discussing it with friends and family, talking to fund managers,” Block says. “It was an exciting time. I was on the cusp of a new career.”•

Adapted with permission of the publisher, Wiley, from The Most Dangerous Trade: How Short Sellers Uncover Fraud, Keep Markets Honest, and Make and Lose Billionsby Richard Teitelbaum. Copyright © 2015 by Richard Teitelbaum. All rights reserved. This book is available at all booksellers.