HONG KONG — Like an odd business hex, two little words strike fear in Chinese companies on Wall Street: Muddy Waters.
Named for a Chinese proverb that roughly means “muddy waters make it easy to catch fish,” Muddy Waters is a New York-based research firm that has carved a niche for itself alleging massive fraud among Chinese firms listed in North America.
The model is simple: Muddy Waters issues a research report detailing alleged fraud, publicizes it, and profits by betting that the price will plunge.
The firm does not disclose how much money it makes off of these bets, but it claims a record of forcing four companies to delist from Western stock exchanges over the last three and a half years.
By one estimate, Muddy Waters has single-handedly wiped out over $7 billion in market value from the companies it has targeted.
In 2011, for instance, the firm alleged that Chinese lumber giant Sino-Forest was rotten to its roots. Within a year, Sino-Forest had been felled. Its share price plummeted from about $18.50 until the Ontario Securities Commission suspended it from the Toronto exchange in Canada, citing alleged fraud. It eventually filed for bankruptcy.
The allegations allowed Muddy Waters to borrow shares, sell them when the price was high, then pay back the lenders when the price was low — a sell high, buy low strategy known as shorting.
Since then, Muddy Waters — and its flamboyant, outspoken founder, the American lawyer Carson Block — have become perhaps the most famous scourges of Chinese companies accused of fraud. Over the last three years, they have gone after nine firms with hard-hitting “strong sell” reports that sent share prices cratering.
The pattern goes like this: On some unsuspecting day, Muddy Waters blasts out a report featuring bold, colorful language. (A subtitle of New Oriental Education’s report was “Magna Cum Fraude,” the commodities supplier Olam was dubbed a “black box” with “uncanny” similarities to Enron, NQ Mobile was called, simply enough, “a massive fraud.”) Hours later, the stock price tanks. Shareholders flee. The company scrambles to defend itself. And then…
Well, that’s where the pattern gets a little wobbly.
In some cases, Muddy Waters’ targets have essentially imploded and been delisted. In addition to Sino-Forest, that was the fate of China Media Express, and, most recently, Duoyuan Global Water, which was taken off the New York Stock Exchange in January 2012.
In other cases, the stock price gets battered, but the company hobbles along. That’s what happened to Orient Paper, which has seen its shares limp around $2.75 from a level of $8.50 before the takedown.
And then, in the last two years, more cases have emerged where companies have, bounced back after being subjected to a Muddy Waters assault.
That happened to New Oriental Education, which has seen its shares exceed their level before Muddy Waters’ 2012 report. And it happened to American Tower Corporation, which the firm continues to say should be valued at $44.58 per share, but is currently trading around $78.
So has Muddy Waters started to lose its touch?
That’s the question swirling around its most recent report on NQ Mobile, a Chinese mobile security company based in Beijing and Dallas. On October 25, Block published a report calling NQ a “total fraud,” arguing that 90 percent of its revenue was fake.
The initial selloff was ferocious. The company’s market capitalization shrank by hundreds of millions. The stock price fell 62 percent overnight.
NQ hit back hard at the allegations. In a 90-page report, the company responded to Block’s accusations, showing pictures of one of its major client’s headquarters, which Muddy Waters had said was “an empty shell with no discernible operation.”
NQ announced it was calling in outside auditors to verify the books, and promised to publicly demonstrate it had millions of dollars in liquidity. The company later released screenshots of bank statements showing accounts with a balance in excess of $100 million in cash.
In the two ensuing months, in fits and bursts, the stock price has crawled back upward — though nowhere near its original level. At the beginning of the year, shares of NQ traded around $6. Just before the Muddy Waters report, they hit a high of about $25.
Now, they’re trading at around $12.
In fact, investor Jim Oberweis, founder of the top-performing China-focused fund, Oberweis Asset Management, doubled his stake after Carson Block’s sell-call to more than 540,000 shares.
Whether he’s proved right or not, the public fracas between Block and NQ has intensified questions investors have about Muddy Waters’ staying power as a bloodhound of financial foul play.
“[Carson Block] is masterful at using the media to use shock and awe to drive down prices whether or not he’s right. It’s unfair that he never tells us what his position is, whether he’s made money, whether or not he’s out of position,” says Bill Bishop, an investor and commentator in Beijing.
“What he’s doing is legal, but there’s no accountability if he’s wrong and he’s done a lot of damage to a stock.”
Paul Gillis, a respected accounting scholar and professor at Peking University’s Guanghua School of Management, also raised questions about whether the fraud could go to the extent alleged by Muddy Waters.
“If the cash is there [in NQ’s accounts], I see no way that any fraud could be of the scale alleged by Muddy Waters. The company is taking some extraordinary steps to clear this issue up,” Gillis wrote on his website, China Accounting Blog.
On November 1, NQ Mobile announced it had transferred $13 million into bank accounts, bringing the cash balance up to $54 million. On November 6, the company said that it brought that total up to $103 million in a Standard Chartered bank account.
In email exchanges with GlobalPost, Carson Block maintained his stance on NQ, and said that the company’s vociferous defense is exactly what you would expect from one that’s been called out for malpractice.
“NQ is a complete fraud. Its actions have been predictable and expected. We release a detailed report, and NQ released a lengthy response designed to confuse the issues and give investors the false impression that NQ provided satisfactory answers to our report. NQ opened a new bank account, and took much longer to transfer in the money than it should have, given its prior insistence that its term deposits were as liquid as cash. This delay strongly indicates that cash had to be obtained from sources other than the company’s own accounts,” he wrote.
Asked about why some companies such as New Oriental Education have bounced back since the initial sell-off, Block said he “should have done more to expose” New Oriental, but that at the time of the report, China’s Ministry of State Security had “interdicted” an employee of Muddy Waters and his family.
“It was a personally anxious, and ultimately painful, time for us. I was unable to muster the focus needed to continue writing about EDU.”
NQ Mobile, for its part, told GlobalPost that it operates with the “utmost transparency,” citing its hiring of PWC, Deloitte & Touche, and Shearman & Sterling to “undertake an independent audit and review of our finances and operations.”
The company further said that “we’re simply not inclined to take any short-seller’s false claims, misleading information and malicious inaccuracies seriously, especially an individual who won’t disclose profit motives, operations or methodologies, let alone a business address or even the names or qualifications of an alleged research team.”
NQ Mobile has said it is filing a lawsuit against Muddy Waters in China.
While there’s no doubt that Carson Block has done valuable — and presumably profitable — work uncovering corporate malfeasance, some investors have started to call for the short seller to show more transparency about his own stake.
When asked by GlobalPost the size of Muddy Waters’ position on NQ Mobile, and whether it had cashed out, this was Carson Block’s response:
“As our disclaimer says, you can assume we continue to be short NQ as we believe this company is a zero,” he wrote. “We don’t disclose our investments or performance because, unlike NQ, we haven’t raised money from the public. We are transparent about our motivations, which are financial and moral, and our intention is to see NQ de-listed.”
The battle with NQ Mobile could end in any number of ways. If Block succeeds in proving his claims, then Muddy Waters will have cemented its influence with China-focused short sellers. But if it’s wrong, the demands may become a bit louder and more insistent for Block’s team to bring some clarity to the (if we may say so) muddy waters of its own affairs.
“I think [Block’s] credibility has been weakened a bit,” says Bill Bishop, the investor. “If he’s right on NQ, which he very well may be, then everything is forgotten. But if it turns out that he’s not right on NQ then it’s going to be interesting.”
“You have to listen to him. You can’t ignore him. But what you’re seeing from sophisticated investors is, there’s more of a willingness to buy after the crater and then sort of figure it out. There was a period where he was right almost all the time, but he’s not been that right lately, so there’s a lot of skepticism. It doesn’t mean he’s not a smart guy, it doesn’t mean he’s not right about NQ. But it’s gotten a lot harder now to find that fraud.”