Sino-Forest controversy puts analysts in spotlight

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As they toured a Louisiana sawmill late last week, a group of Bay Street analysts began to feel their BlackBerrys vibrate with urgent messages from back home.

Something strange was up with Sino-Forest Corp., a fast-growing forestry company that owns trees in mainland China, is managed out of Hong Kong but has been listed on the Toronto Stock Exchange since the mid-1990s. Every one of the Canadian analysts had been positive on the company's prospects; each one recommended owning the shares. But the stock was now in freefall, and confused traders and clients wanted to know why.

Soon enough, they got an answer. A research analyst, Carson Block, had published a report full of sensational allegations, in the most inflammatory language possible. Sino-Forest, he wrote, was a "fraud" that had raised piles of money from investors in a "multibillion-dollar Ponzi scheme." More specifically, he claimed that Sino-Forest had inflated the value of its timber holdings and produced fictitious revenue.

That Mr. Block was previously an unknown - and was short-selling Sino-Forest stock in an attempt to profit from its fall - seemed to matter little to the market: over the course of two days, investors knocked more than $3-billion, or 71 per cent, off the company's value. The company denies all the allegations.

More than a week later, a few things have become clear. First, there were problems with Mr. Block's analysis. Second, serious questions still remain about Sino-Forest's business, its accounting and its assets - questions that the company has set up an independent committee to resolve. And third: if there is any substance to the allegations about Sino-Forest, Bay Street analysts failed to sniff out the problems. Before the Block report, seven out of seven Canadian-based analysts rated the shares a buy.

It will likely be weeks, perhaps months, before investors hear the truth of the matter. But the furor caused by Mr. Block's report is also causing new scrutiny of the work that analysts do at investment dealers, and raising questions about the obstacles they face when covering Chinese public companies, even those listed on Canadian and U.S. stock exchanges.

Not only is there a distance barrier, but there are also language and culture divides that make it much harder to track the companies they have been assigned. Yet investment banks encourage their analysts to cover these companies like Sino-Forest because they cross the Pacific to tap the pockets of North American investors. To do that, they need to hire investment banks, and these contracts pay big equity and debt underwriting fees.

Sino-Forest has raised more than $2-billion in equity and debt since 2007. To compete for a piece of that business, investment banks normally have to employ an analyst to cover the company. Nearly all the investment banks whose research departments cover it have played a role of arranging the company's financing. Credit Suisse Securities Canada and Dundee Securities have been the two most-favoured dealers, and TD Securities has also been a prominent player. On the equity deals alone, the underwriters have been paid more than $35-million in fees.

The report by Mr. Block's firm, Muddy Waters LLC, has forced analysts to stake out a position. Aside from Richard Kelertas at Dundee Securities, who called the Muddy Waters report a "pile of crap," the analysts have mostly stayed mum and simply put the stock under review. On Friday, Paul Quinn at RBC Dominion Securities noted that there is "evidence mounting in Sino's favour."

But no one has yet been able to verify Sino-Forest's Chinese contracts, or knows if they can be relied on.

In the wake of the collapse of Bre-X Minerals and numerous dot-com darlings more than a decade ago, Claude Lamoureux, former head of the Ontario Teachers' Pension Plan, was a part of a committee that studied the standards that apply to analysts and came up with reforms for the system. But the industry, he says, including both analysts and auditors, still do not have to take enough responsibility for their work.

"Analysts should do their homework, should check things," he said. While the allegations against Sino-Forest remain unproved, "if Muddy Waters is right, a lot of people have not done their homework," Mr. Lamoureux said.

There have been some skeptical voices on Sino-Forest, even before Mr. Block. Months before he shocked the market, an analyst across the Pacific raised some of the same questions.

In early March, Anissa Lee, a credit analyst with venerable Japanese investment bank Nomura Securities, put out a report that put Sino-Forest's valuation in the spotlight. Ms. Lee wondered why Sino-Forest was able to sell its timber for so much money and she was concerned that the company's top five customers, which accounted for 60 to 70 per cent of its revenues for the past three years, have never been disclosed.

She pointed out that co-founders Allen Chan and Kai Kit Poon, have a fairly low stake in the company at 2.68 per cent and 0.07 per cent respectively, "which is not very common among Asian high-growth companies." She also raised questions about the company's cash flows.

"I actually used to like this company a lot," Ms. Lee said in an interview from Hong Kong. When she started covering Sino-Forest's bonds, "it was one of the very first companies in the high-yield space which one can play the China growth story."

For that reason, she decided not to attack the company and instead asked to sit down with management. They agreed. But she still found she could not get comfortable with their story.

"It's very difficult to verify information," Ms. Lee said. She ultimately put out a negative report, but it didn't have nearly the same effect as Mr. Block's, which she partly attributed to his use of more bombastic language. Dundee's Mr. Kelertas alleged that Mr. Block pre-marketed the report to some hedge funds, so they were primed for any negative market reaction.

To bridge the divide and make it easier for analysts, Sino-Forest hosted annual China site visits in recent years. Each time they commenced with a half-day meeting with Sino-Forest's CEO in the company's Hong Kong office, after which the group traveled together to mainland China to tour plantations and other facilities. Sometimes, the company brought a Chinese government representative to speak to the group, including forestry officials.

However, even though the tour groups saw trees and walked through a few facilities, the site visits - which are common practice among many companies - provide only a snapshot of the firm's operations. Sino-Forest says it holds more than 700,000 hectares of land around China, and it would be difficult for any Canadian analyst - no matter how hard-working - to figure out if that number is wrong.

Still, the issue has again raised questions about the responsibilities of analysts who investors rely on for advice.

One of the reforms that stemmed from the Crawford report a decade ago was additional disclosure. As a result, analysts' research reports now come with lengthy disclaimers that would appear to absolve them of liability. For instance, they tend to say that the bank issuing the report could have conflicts-of-interest, is not responsible for the information in the report being correct, and is not liable for any damage that stems from it.

This lack of responsibility extends beyond analysts, Mr. Lamoureux said. "The analysts will tell you 'we rely on the auditor.' The auditor will tell you 'it's not our job to catch fraud.' … A lot of the work of auditors is not worth the paper it's printed on."

The end result is that, for investors, it's "buyer beware," said Leo de Bever, head of the Alberta Investment Management Corp. He considered investing in a private forestry project in China more than five years ago, before coming to AIMco, and decided he wasn't comfortable with the prospect. Things in China are "much harder to verify," he said. Sino-Forest investors now know that all too well.

With files from David Ebner in Vancouver.