Short selling and fraud: The case of Silvercorp Metals

There has been a steady stream of anonymous fraud allegations aimed at Canadian companies with a Chinese connection. Are they for real? Or are short sellers trying to drive honest companies into the ground?

(Illo: Daniel Stolle)

The letter arrived at the Vancouver office of Ernst & Young on Aug. 31 in an envelope bearing $6 in U.S. postage. There was no return address and instead of salutations, it began with a headline: “Potential $1.3 billion accounting fraud at Silvercorp.”

Rui Feng, the founder and chair of Vancouver-based Silvercorp Metals Inc., was in Beijing at the time. He heard about the letter over the phone from Bob Gayton, head of the audit committee, who’d been alerted by Ernst & Young, auditor to the mining company, which at the time had a $1.5-billion market value, thanks to its two operating lead-zinc-silver mines in China and undeveloped properties in China and B.C. But Feng had an inkling something like this was coming.

Two weeks earlier, he had gotten a call from the company’s largest shareholder, Texas-based fund manager US Global Investors Inc., warning that a broker at another firm had received an anonymous call, saying Muddy Waters was about to publish a report on Silvercorp and US Global should dump its stock. Muddy Waters is the New York–based research company headed by China skeptic Carson Block, whose allegations in June of fraud at Sino-Forest Inc. began the implosion of what had been the biggest forest company on the Toronto Stock Exchange.

Within days of the Sino-Forest report’s release, the silver miner’s stock dropped 10%, simply because it was another China-related stock. But there was worse to come. In August, Feng learned that short positions in his company had increased four times over. Short-selling is the practice of borrowing stock and selling it at the current market price but paying for it later, on the expectation that the price will fall; it’s a way of profiting from a stock’s decline. By September, the short positions represented 13% of Silvercorp’s shares outstanding.

Now Feng, who had rushed back to Vancouver Sept. 2, had in his hands the letter, copies of which had also been sent to regulators and media outlets. The letter made several allegations of fraud at Silvercorp—most importantly, that its reported profit of US$66 million in 2010 was a lie and it had instead lost half a million dollars, plus that its reserve estimates were exaggerated. The claims, in Feng’s opinion, were preposterous. “It’s like somebody sending a letter to your wife saying you’ve got another 10 girlfriends and five kids outside of marriage,” he says.

Six months later, Silvercorp has weathered the storm, but at a cost of more than $2 million in investigation, audit and legal fees, as well as immeasurable stress. Now, without any help from Canadian regulators, the company is pursuing retribution against its accusers through the courts. Like a blameless relative tarred with the same brush as Sino-Forest, Silvercorp’s odyssey is sparking a wide-ranging discussion about the role of short sellers, the accountability of anonymous accusers, and the challenges of financial reporting across oceans. “The guy pours a bucket of dirt on you, and it’s up to you to clean up. If you have no money, you’re dead. You’re stuck with the dirt forever,” Feng laments. “Basically it’s a question of market integrity. Will you allow somebody to come into your market to manipulate it?” So far, Canadian authorities appear to have done just that.

When the first missive arrived, Silvercorp’s management and board debated whether and how to respond. “This was an anonymous letter. It was not public,” says Feng, his English still heavily accented after 24 years spent living in Canada. “We had a discussion and said, ‘Let’s make this public,’ because they’re going to make this public maybe in a couple of days.”

So Silvercorp issued a release disclosing the contents of the letter and responding to the allegations. The deliberate transparency didn’t help at first. Share prices plunged. Never mind that Silvercorp’s chief financial officer, Maria Tang, had cobbled together as much evidence as she and her team could in the short time to demonstrate the legitimacy of Silvercorp’s figures. This evidence included Chinese tax assessments showing how much tax the company had paid. There were also bank statements, reserve estimates by an independent American geologist and historical records of dividends paid out to shareholders—which would have been improbable if, as the letter writer claimed, the company’s mine in China was losing money.

Silvercorp also announced it was forming a special committee of independent directors to investigate the allegations, and bought back more than four million shares. Feng personally spent $1.7 million to acquire some 200,000 shares—not the way a fraud artist typically behaves.

He also met with key investors to reassure them in person. On Sept. 13, Feng was in Boston doing just that when a second set of allegations surfaced. These appeared on two obscure websites, and, the latter a platform, by its own description, “for its contributors to anonymously share their best investigative research and investment ideas without fear of threats and unwarranted retaliation.” These accusations referred to “Questionable Customers, Geologists, Production, Quality and Serious Related Party Failures” at Silvercorp.

Feng spent the entire flight back to Vancouver on the phone. He arrived in the office at 1:30 a.m. to walk through the response with his staff. The next morning, Silvercorp shares hit a low of $5.80 on the Toronto Stock Exchange, down from nearly $11 in June. But by the end of the day, after the company released its documentation, they had recovered to $7.40.

On Sept. 19, still more charges were posted on Alfredlittle. This time, Silvercorp’s response was quick and perfunctory, pointing to already disclosed documents. Later that month Silvercorp flew a group of stock analysts to China so they could check out its mine in person. Meanwhile, the company’s special committee hired KPMG to conduct an independent audit of its operations, which included sending accountants to China.

There would be two more reports critical of the company on Alfredlittle, but Silvercorp stopped bothering to respond. KPMG issued its report on Oct. 24. Its forensic accountants determined that Silvercorp’s financial statements were substantially correct, though some numbers from Chinese subsidiaries were not available. By and large, investors’ concerns about the company’s reporting were put to rest.

The battle scars have been slow to heal, though. The audit and other measures to restore Silvercorp’s reputation have cost the company $2.5 million and counting. Moreover, the taint of impropriety, once established, is hard to erase. Employees heard about the investigations, saw auditors coming and going and began to wonder about their future with the company. Damage can be done long before investigators render a decision, Feng argues. “I mean, what happens if Sino-Forest is not a fraud? The company will be destroyed.”

The anger he and others feel at short sellers’ targeting of Chinese companies doubtless played a role when Silvercorp filed suit in New York against the websites China-stockwatch and Alfredlittle, and associated individuals, for defamation back in September. In January, following its own investigation, it added EOS Holdings LLC and International Financial Research & Analysis, as well as three executives at the companies. At press time, none of the parties has filed a statement of defence.

Silvercorp will be hard-pressed to prove the defendants’ intent to manipulate the marketplace, however. “There’s nothing inherently evil about shorting a stock,” says University of British Columbia law professor Cristie Ford. “I think you can reasonably say that shorts provide a lot of discipline and to some extent keep companies honest.” Short selling, in other words, discourages fraud by giving investors the incentive to look beyond the story the company tells.

Still, it’s easy to see how a combination of factors could induce unsavoury market participants to “short and distort” stocks—that is, to take short positions, then spread misleading information to capitalize on investors’ fear and profit from the stock’s resulting decline, to the detriment of the issuing company and the broader market’s integrity. The anonymity of the Internet reduces the need for accountability. The democratization of the short position beyond the circle of market insiders means there are now short sellers with little or nothing to lose. Finally, the success of Muddy Waters’ assault on Sino-Forest inspired copycats.

Asked to make a case for the work of short sellers like himself, Muddy Waters’ Block said in an e-mail to Canadian Business: “We think the real estate crisis [in the U.S.] could have been less severe had short-sellers felt comfortable enough to speak publicly about the problems they found with subprime lenders. There have been Chinese companies listed in North America that have engaged in fraud and short-sellers have undoubtedly played an important role in exposing them.”

Like Muddy Waters—which takes its name from a Chinese expression about where fishermen find it easiest to fool the fish—Alfredlittle was created in 2010 and publishes postings that challenge the reporting of companies that operate in China but are listed on North American exchanges. Managing editor Simon Moore (one of the individuals named in Silvercorp’s defamation suit) says the site stands by its allegations. “Our contributor’s view has not changed after the KPMG report was released to the public. The KPMG report specifically addresses the allegations made by the anonymous regarding Silvercorp’s cash. To date none of the concerns made in any of the A*L reports ever mentioned Silvercorp’s cash.” (Alfredlittle’s allegations focused on “inflated” earnings and the size and quality of mineral reserves. Chinastockwatch has gone offline since it published the first report.)

Like Block, Moore sees short-selling sites as a form of consumer protection. “The bottom line is, all information is valuable when presented through well-documented reports. Investors are harmed if they are only allowed to hear the bullish arguments of a company. Sadly, the companies that have sued A*L are trying to censor information from ever reaching the public and as a result harm the financial community by doing so.”

The fact that more respectable parties share the shorts’ skepticism about foreign accounting further complicates Silvercorp’s quest for justice. According to the Canadian Public Accountability Board, an independent policy body for the accounting profession, there is genuine cause for concern around TSX-listed companies that primarily operate in China. In a review of 24 such companies released in February, it found 12 whose audits it considered deficient. “In too many instances, auditors did not properly apply procedures that would be considered fundamental in Canada, such as maintaining control over the confirmation process,” the report concluded. It also found “a lack of professional skepticism” when companies’ reporting ought to have raised red flags. The CPAB doesn’t consider Chinese companies unique in this respect; it plans to expand its review to companies operating in other developing economies.

Quite apart from the fact that Silvercorp is a Canadian-based corporation with Canadian senior management (not to mention mineral assets in Canada) and is already audited annually by Ernst & Young, Feng disputes the characterization of China’s business culture as lacking transparency. “A lot of Canadian companies have international mines. How can you say Mexico is better, America is better? You had [New York–based derivatives broker] MF Global just blow up. They couldn’t find $1.2 billion. That’s clients’ money. In Japan, you have [fraud at electronics maker] Olympus, which has been going on for how many years? These frauds are bigger than any fraud that has been exposed for China.”

Feng adds that as a company operating and reporting in multiple jurisdictions, Silvercorp must keep several sets of books: one under each of Canadian, Chinese and American generally agreed accounting principles (GAAP), and another under International Financial Reporting Standards (IFRS). On top of that, it must report on the calendar year (not its own fiscal year) for Chinese tax authorities. In the mining business, you may not even ship every quarter, and a load of ore might be shipped but not yet paid for at time of reporting. Short sellers, says Feng, exploit these discrepancies in the reporting and paint them as fraud. “How do you define revenue? Each business is different, right?” he asks. “That’s the game they are playing.”

Similar allegations focusing on reporting disparities in different jurisdictions were brought against Harbin Electricity Inc. last June, whereafter its stock briefly plunged below US$6 on the New York Stock Exchange. Rather than fight the allegations, the company’s founder and chairman, Tianfu Yang, took the firm private at US$24 a share, a price well above its six-month average even before the trouble started. “The guy must be stupid if he’s a fraud. He spent US$800 million,” Feng says.

Another New York–listed target was Spreadtrum Communication Inc. Its shares collapsed in late June but recovered through the fall, while its accuser, Muddy Waters, has faced declining credibility. In November, the research firm issued a report claiming Focus Media Holding Ltd. had exaggerated its digital advertising reach. Its shares initially dropped 39%, but Focus has regained virtually all its lost ground. “What seems to be lacking is a present-day smoking gun,” Florida hedge fund manager Eric Jackson told Bloomberg in February.

If Block is losing relevance, the anonymous sites are barely breathing. Moore said Alfredlittle, which charges no subscription fees, was originally meant to grow a large audience and then sell out to a financial news service, but the need to protect its contributors’ anonymity has caused such hopes to fade. If they worried about being burned by a corporate fraud before, investors today are more concerned about making the wrong bet based on outsiders’ supposed revelations.

Though Silvercorp now appears to have the upper hand over its detractors, one wonders why a mid-cap mining company should be leading the charge against anonymous accusers and their presumed short-selling. (The evidence suggesting a link between those who published the reports and those who shorted Silvercorp stock is at best circumstantial.) There’s nothing to stop securities commissions from prosecuting short-and-distort schemes under the same sections of the various provincial securities acts that prohibit pump-and-dump schemes, says UBC’s Ford. These sections prohibit all kinds of fraud and market manipulation.

So far, shareholders and analysts have not publicly questioned whether investigating the short sellers and pursuing them in court is a profitable use of Silvercorp’s cash. Feng justifies the action on the grounds that the best defence is a good offence. He fears that the shorts will keep hounding Silvercorp, possibly at the urging of complicit hedge funds, unless it can demonstrate its innocence of the fraud allegations in court. In November, one of the company’s mine engineers in China passed along e-mails he’d received from a representative of Guidepoint Global, a company that gathers competitive intelligence. The e-mail correspondent, who claimed to be acting on the request of an American hedge fund, offered the engineer money by the hour in return for information on Silvercorp. Separately, a sales manager in China received a call from a man claiming his inquiry was already OK’d by Silvercorp executives (it was not) and attempted to get the sales manager to confirm some leading questions.

Silvercorp, the exchange it trades on and at least some of the attackers are Canadian, but the activity of shorts, reputable and other wise, spans the globe. It is fitting, perhaps, that it will likely be a New York court or Chinese regulators (who in December told Silvercorp they had opened a criminal case against the company’s accusers) that give the company a measure of justice.