Last week, Chinese timberland company Sino-Forest Corp. (TREE.TO), a company which has been under investigation by Candidian regulators for possible fraud, announced that it would seek banruptcy protection. The company has been de-listed by Candian authorities since August 2011.

The company made big headlines twice last year. The first time was when a firm known as Muddy Waters, put “ out a report claiming the company was The Olympus of China.” Olympus was involved in a multi-decade accounting scandal, which Japanese regulators recently uncovered.

The company also made headlines, as John Paulson, was reported to have lost $500 from his investment in the company.

The story does not end here. On Friday, after the bankruptcy filling, Sino-Forest announced a lawsuit against Muddy Waters for $4billion. At first the lawsuit sounds absurd, but read further, because we have reason to believe that it might not be so crazy after all.

Below is a brief description from an article by David Benoit, inThe Wall Street Journal (emphasis ours):

The suit alleges Muddy Waters and others made “hundreds of millions of dollars and perhaps more” by taking down Sino-Forest shares.

Block responded in a statement that: “The lawsuit is entirely without merit. We stand behind our work and have no doubt the outcome will be favorable for us.”

About Sino-Forest’s bankruptcy filing, the  Muddy Waters statement added that: ”This is yet another indication of what we have said all along, that Sino-Forest’s management has committed a massive fraud and has deceived its shareholders and creditors.”

The suit alleges that Muddy Waters, along with 100 unnamed hedge funds, set up short positions in Chinese companies with listings on Western stock exchanges. The suit then alleges the group would put out “what is popularly described as a ‘bear attack’ on the companies” in the form of a report with a “veneer of truth” that would create a “cataclysmic effect on the stock price.”

The suit adds that Muddy Waters tried to “road-test” its strategy on other companies first and saw that it worked, even when the companies refuted its claims.

“Wherever Muddy Waters looked, they found fraud,” the suit says. “Muddy Waters and Block were ready for the big leagues, and along with the other defendants, determined to take down Sino-Forest as their next victim.”

In the lawsuit, Sino-Forest says Muddy Waters used “inflammatory language” to increase the impact of its allegations. Sino-Forest only refers to the report as “research” in quotations. The suit says the report used the word “fraud” at least 39 times and “sensationally” described Sino-Forest.


ValueWalk has some exclusive information about this lawsuit. While Sino-Forest  may very well have been involved in fraud, the company’s allegations are partially true. 

Sino-Forest is a Chinese Reverse merger. There are hundreds of them on the US stock exchanges. Many of them have been exposed as frauds. The first short sellers, started to short these companies around 2009.

At some point Muddy Waters got involved in researching these companies as well. Muddy Waters was in touch with some of the hedge funds, who also researched the company. Muddy Waters eventually rose to fame, and their announcements would make stocks decline significantly. The hedge funds would wait to short right before Muddy Waters would release their research.

We do not know if this would be illegal. It likely is a grey area of securities law. On initial thought, this author would say this practice is unethnical but not illegal. Securities lawyers involved with firms, which shorted Sino-Forest, claimed that the practice was legal.

If one heard that David Einhorn was going to announce he was short a stock tomorrow, and one shorted the stock that day, would that be illegal? Here it is slightly worse/different since the firms were in contact with Muddy Waters.

However, so what? The firms planned to short the stocks and just waited for the optimal time.

Furthermore, many of these short sellers would have shorted the stock regardless of whether Muddy Waters even existed or not. Hedge funds were shorting many of these types of companies before anyone even heard of Muddy Waters. Some of these hedge funds had postions in Sino before Muddy Waters had the reputation which is has today. They also hold many short positions in companies Muddy Waters has never even researched.

However, there could be grounds for a suit. The suit focuses specifically on Sino-Forest, and perhaps it is illegal to collude with other short sellers to short a specific stock (even if it is a fraud). This case, if it goes forward, could open a pandora’s box to some actions by hedge funds, which almost no one knows about. What is insider trading or in this case fraud? this question has never been answered. But similar cases likely occur all the time.

The other charges we do not know if they are true, but we doubt them. If Muddy Waters could pick so many companies that were actually committing fraud, why would they focus on companies which were not. We doubt they did trial runs on other stocks. We also likely would have seen huge declines in the stocks, and there would be research reports from Muddy Waters on the companies. As all companies on the verge of bankruptcy do, Sino-Forest is grasping for straws.

During the financial crisis, many rumors were spread about firms, which caused huge price declines. The companies blamed short sellers for spreading rumors. Could this case of a small Canadian company, which possibly committed fraud, open a larger series of investigations to these types of actions across the industry? Only time will tell.

(Disclosure: No position in the company)

(An earlier version stated the ticker of Sino-Forest as FMCN. The ticker has been corrected to TRE.TO. FMCN isis Focus Media Holdings another company Muddy Waters alleges is a fraud.)