China short-selling: Short shrift?

There is a place for short-sellers in every market and research firm Muddy Waters deserves some credit for revealing the exaggerated earnings of several companies. Many of these firms went public in the US through reverse mergers so they were subject to less scrutiny. There was an information asymmetry and Muddy Waters filled the gap. A number of PE-backed companies were among those found wanting.

Suddenly a host of researchers were parsing filings in search of the next big fraud, with hedge funds all too willing to pay to see reports weeks before they were released into the market. My employer wanted a slice of the action and formed a dedicated research unit. The death threat represented the first occasion on which members of this unit got their fingers burnt. The researcher in question had completed his analysis of the company and come up with a list of questions. He decided to ask the company chairman for answers.

The chairman's response indicates the kind of pressure these executives were under. In many cases, the reverse mergers that led to their companies going public were uneventful processes led by intermediaries. Small-scale auditors waved them through even though (as it turned out) they had neither the bandwidth nor the aptitude to dig deep. Now these executives were being asked tough questions for perhaps the first time.

There are two schools of thought. Either the chairman was a fraudster who had found himself cornered and was willing to say anything to find a way out; or he was honest man who had built a company from nothing and now feared potential ruin at the hands of short-sellers willing to publish anything to make a quick buck.

In reality, people sit at different points on a sliding scale. Throw in extenuating circumstances such as poor third-party advice, confusing record-keeping processes that may mean there is a very good reason why numbers don't add up, the fact that many Chinese companies underestimate the rigors of the US disclosure-based system, and founders' tendency to take the pragmatic, if the not the most copper-bottomed route to corporate success and it isn't always possible to reach a definitive conclusion.

What made me uncomfortable - and this was actually a factor in my decision to leave the company - was doubts over quality control. First, I was unsure whether the newly-formed research unit had the ability to conduct the level of research required and then deliver it in the language to which institutional investors are accustomed. Second, I was unsure whether the end users really cared about the first concern. Mud sticks, or at least it does for long enough to execute a trade.

To be fair, the market is a great leveler. A research firm or short seller that repeatedly cries wolf will ultimately be ignored and no longer able to move stock prices in the desired direction. Companies have also been known to rebound quickly and strongly from such setbacks, just as others have rightfully collapsed.

What makes the recent Tianhe Chemicals case interesting (and relevant to AVCJ because it is a Morgan Stanley Private Equity Asia portfolio company) is the party making the allegations of fraud eschews accountability. Indeed, Anonymous Analytics, a faction of activist and hacker network Anonymous, positions itself as the faceless - and not profit-driven - scourge of dishonest corporations.

Is this organization everything it says it is, and if so, does this make the accusations any more credible? With Tianhe denying the allegations and Anonymous Analytics standing by them, it is up to the market to decide. But past experience suggests this is a murky pond: the identities, motivations and abilities of those conducting the research are difficult to fathom.

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• Topics
• Regulation
• Greater China
• Investments
• Growth capital
• China
• regulation
• Morgan Stanley Private Equity Asia