No Sympathy: the China Short Seller Brawl Heats Up

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As an American, I usually approach a fight with the expectation of labeling one party the “good guy” and the other the “bad guy.” Sure, a black-and-white world view is somewhat unrealistic and limiting, but if it was good enough for George Bush and Darth Cheney, it’s good enough for me.

A kerfuffle going on in China right now about the practices of certain firms known as “short sellers” has forced me to discard my usual analytic framework in favor of the FRO approach, as in “these guys can all fuck right off.” I think it’s more appropriate given the industry and the folks involved.

First, a quick summary from Marbridge:

A group of 61 Chinese IT entrepreneurs including current former Google and Microsoft executives led by Kai-fu Lee, chairman and CEO of Beijing-based incubator Innovation Works, has established the website, arguing that Citron’s modus operandi is select legal corporations with only minor or no issues as attack targets, and make false allegations that cannot be verified by its US readership.

In response, Citron founder Andrew Left said that criticisms leveled at himself by the group amounted to a “personal jihad.”

This jihad makes me want to respond with a jeremiad of my own, but I’ll try to keep this post to a reasonable length.

OK, so on one side you’ve got short sellers like Citron and Muddy Waters. They take short positions, issue critical reports, and hope enough shit sticks to the wall that the stock tanks and they make money. The term “vampire squid” comes to mind, but I believe Taibbi already trademarked that. If some of the crap these guys sling out there blows back on them, well, them’s the breaks. No sympathy from this blogger.

On the other side, you’ve got the poor, innocent Chinese companies that have been maliciously libeled. [Wait, hang on a second, fits of laughter. Right, I’m back. Wow, that was intense. 8.7 minutes laughing so hard that I nearly broke two ribs.]

We can quibble about the accuracy of individual research reports, but if we take the set of US-listed Chinese companies that have been the subject of investigations and litigation concerning improprieties like accounting scandals, we’d have to admit that there is more going on here than short sellers muddying the waters (so to speak) to make a buck. There’s a reason why many, though certainly not all, of these companies chose to avoid scrutiny via the “reverse merger” listing approach and others have blatantly fabricated information. What’s that f-word I want to use here? Oh yeah, “fraud.”

Are some of these companies being unfairly targeted by short sellers? Undoubtedly. But the crying, the wailing, the gnashing of teeth, and rending of garments has failed to elicit my sympathies thus far. Why? They chose to list in the U.S., where a company is free to raise money on the capital markets by engaging in a rigged system that benefits a few to the detriment of everyone else. Fraud and insider trading are only the dodgy practices that are illegal — most of the other ways the system screws over non-institutional investors are perfectly legal. Free free to call me a dirty Commie, but please don’t try and pretend Wall Street is a pure and unsullied example of perfect competition in action.

Companies that do a listing benefit from this system, and at the same time, they open themselves up to whatever shit folks want to sling at them. That’s the “public” part of a public listing, I suppose. And if the smear tactics get out of hand and your press releases aren’t remedying the situation, one can always resort to libel suits, although that would mean extensive discovery and an uncomfortable disclosure of information. Can’t have that, can we?

Thus far, I’m not inclined to speak up for any of these folks. But what about all these “entrepreneurs” out there who are now blasting Citron?

Call me a cynic, but unless I know otherwise, I’m assuming that every last one of them has lost money because of a Citron or Muddy Waters report. In other words, these guys are probably biased as hell, and their statements should be looked at just as closely as a short seller research report. That being said, Kai-Fu Lee’s critique of Citron’s recent foray into the world of search engines is quite persuasive, if you ask me.

Did I mention that I don’t trust anyone?

The term “entrepreneur” sounds much more positive and romantic than “investor.” But at the end of the day, one side is betting one way, and the other side is betting the opposite. We’re dealing here with listed companies, various kinds of investors, and financial service firms. Poor innocent victims? I’m having trouble locating any.

One last group to talk about: the consumers of short seller reports. You know who you are, fund managers and various analysts. And you’re perhaps the worst of the bunch.

Why does the short seller business model work? Kai-Fu Lee’s description is spot on:

[W]hat is despicable is how these short sellers take advantage of the information asymmetry between China and the US, and write reports full of holes and lies, knowing that their American readers have no way of verifying them.

Now, Lee would probably sympathize with these “American readers” and their inability to verify the information they are given on Chinese companies. Granted, it is pretty much impossible for most analysts to follow up on these sorts of allegations, even more so now that the government here has disallowed independent AIC due diligence (see earlier posts here and here).

But I’m not swayed by the sob stories. In many cases, these are the same folks whose initial investment decisions were also made with incomplete and unverified information. Why would anyone, for example, choose to put their clients’ money on the line with a reverse-merger company that is obviously averse to full disclosure of relevant information? Coming back later and complaining about the inability to verify the allegations in a short seller report seems rather hypocritical.

Moreover, no one is holding a gun to anyone’s head and forcing them to sell in the wake of a Citron report. Yes, investors behave like sheep, but the precipitating factor for the stampede (to mix my animal metaphors slightly) must have at least a tiny sliver of credibility. For short sellers, that means a track record that includes a victory or two in the past; alternatively, there may have been red flags concerning a certain target for a long time, and the short seller report merely reinforced what everyone was thinking.

I have to admit that these comments by Citron’s Andrew Left do make some sense:

Citron founder Andrew Left defended his company’s reports.

“Movements only evolve around real threats,” Left said, according to a Wall Street Journal report. He added that Lee has distorted his reports.

“If what I wrote was false, then you wouldn’t need a movement around it. … I am more than happy to defend (my statements) in a court of law,” he was quoted as saying.

Kai-Fu Lee and his compatriots say that these short sellers are full of shit and shouldn’t be taken seriously. But enough folks do just that, and either they have a somewhat credible reason for doing so or, alternatively, they are completely mindless sheep, in which case American markets are so fickle that no one should ever list there again. Or to put it another way, if Citron is a serial liar, won’t investors eventually figure it out, or are they all brain-dead zombies? I’m not sure which is worse.

You might still be thinking, “But surely there must be a few innocent Chinese firms that have been unfairly targeted by nefarious short sellers? Doesn’t that justify the condemnation?”

No doubt there are some bona fide victims out there, and that sucks for them. But that’s what they signed up for, and they are free to fight back with their own media campaigns and/or litigation; perhaps they can hire back the PR guys that helped them with their IPO hype. For everyone else, don’t even bother playing the innocent victim card; I’m not buying any of it.

Maybe I’ve been reading too much Elmore Leonard, but everyone’s got an angle, and none of ’em can be trusted.

6 responses on “No Sympathy: the China Short Seller Brawl Heats Up

  1. Tim

    I’ve been loosely following some of these reports from short sellers of reverse mergers, in particular Muddy Waters’ reports. You mention that there are undoubtedly innocent victims of these reports is this because you believe the analyst just as morally vacuous as the company’s they analyze and so there must be at least one innocent company caught up in the fray?

    Short sellers and these analyst, I have always believed, play a vital role as market watch dogs. It is often bottom feeding, but without these reports I wonder if SEC investigations on many of these firms would have been initiated when they did or even at all.

    I suspect we are going to see more variations on this theme as more and more outbound investment reaches Western shores. Many Mainland Chinese are unfamiliar with concepts of full-disclosure or how independent institutions, namely a free press, actually work. Fraudsters joining together to justify their fraud in an arena of free exchange, though, sounds like a WWF smackdown event.

    Solid analysis but you appear to be taking both sides rather than none at all.


    1. Stan Post author

      I prefer to think of it as taking no sides, but if you’re asking would I outlaw short sellers, the answer is no.

      Everyone is fallible, so I figure there must be at least one innocent company out there. But that doesn’t matter in the grand scheme of things.

  2. D

    The French poet Baudelaire said “the finest trick of the devil is to persuade you that he does not exist”. Come with me as I briefly explain one of theories I have on all this:

    The best things Chinese companies did around 2002/2003 was to persuade investors they did not exist. How? They stopped issuing so many press releases in English. If you map and track the amount they issued in English for the benefit of foreign investors (I mapped it, because that is what my company did back then), you will see a precipitous drop-off around SARS in 2003.

    Why? Well, if you remember the devastation of SARS in China you will know it killed many small tech businesses and hobbled many more (it killed two of my businesses). During the SARS period, many companies temporarily closed and Internet cafes were forced to shut. During this period, Internet penetration in China was still not so high. At the time, most Internet users did not have computers at home; instead they used computer terminals at Internet cafes, at the office, or at school. All of these public places were temporarily closed for sometimes weeks.

    For the Internet companies like NTES, SOHU, and SINA, this should have been a big hit to their revenue since they would have fewer users online, and fewer eyeballs for advertisers to pay for. But that did not happen. Instead 2 things happened:
    1) Some research firms and some of the tech companies issued reports and press releases stating that during SARS they had more users online since now users had nothing else to do but get online since so many offices and businesses were closed. During SARS, Chinese were not going to public places like parks for fear of contracting SARS, so the tech companies were saying these users were now online more. Huh? How?!
    2) There were rumors of stock churning in Hong Kong and China of the US and HK listed Chinese companies.

    If you go to a site like Google Finance, you can easily map and see that around the SARS period was when most Chinese tech firms surged forward in their stock prices. Their stocks skyrocketed! The increases do not appear to make sense, but the observations made above fit one reason for why this happened. Western investors saw the emperor with no clothes and thought him rather fine.

    One of the best things publicly-listed Chinese companies have done is remove much of the ability for Western retail investors to glean decent info about the companies. In the absence of press releases (except for compliance-related SEC or exchange releases) it has always been nearly impossible for these investors to understand the China market.

    One way they can find out info is via some of the research organizations. But I know some of the reports these firms submit are suspect. In the past, one of my companies sent cease-and-desist letters to one of the biggest firms twice because they were copying some of my own company’s business intelligence and displaying as their own on their website. In another case, a 3rd-tier Chinese search engine approached my survey and research business for us to produce a survey that showed their search engine as the #1 fastest growing search engine. We declined. That search engine went to another company and we saw the probably-fraudulent report issued later showing this weak search engine (which I think does not exist anymore) was China’s fastest growing search business. This research company’s letters have also been part of the pre-IPO prospectuses of a few recent listed Chinese companies.

    Chinese listed companies have had smooth sailing for years because they were able to craft a great story and manage the media and news about themselves to Western investors.

    In 2004, the CFO of one of China’s biggest tech companies (he know works for a VC firm) spoke to me on the phone a few months after they IPO’ed and threatened to sue because we issued some pretty innocuous intelligence on his company that he found offensive. We retained the information and did not change it — it really was not that “bad” — and he seemed to clear his head in subsequent days. My point is that these companies sometimes know they are on unstable footing, so they want/need/must control their news.

    Before the incident above, I was partnering with one of China’s largest portals on mobile services. They massively screwed up the partnership and we lost lots of money. They apparently screwed up a few other mobile partnerships at that time too. They fired their VP of Mobile (she then went to another tech company and allegedly got a promotion). That was a material dismissal of a top employee managing a high-revenue generating department, but foreign investors never knew that firing took place. We all learned by 2005 and 2006 that the companies’ mobile departments were breaking the laws and the Chinese government finally started sanctioning companies.

    The Chinese companies’ debacles now are partly a result of their own making. In some cases they chose to limit access to information by not publishing more info for Western investors. In the absence of information, extremes rule unfortunately. Chinese tech companies listed in the US have really not faced much scrutiny and they should be thankful it’s been an easy ride so far.

    Chinese companies should be thankful Bloomberg, Reuters, and AP have such limited resources in China.

    Ultimately, investors in Chinese companies have been winning. So why should they stop the party? I do not know if the short-sellers’ reports are accurate, but I do know they lend a good balance to give the markets an even playing field.

    Many more insiders I know have much, much, much more information to share. So hopefully in the next 10-30 years we will hear some of it. I have much more to say too, but I will leave it at that.

      1. D

        Keyser Söze paraphrased Baudelaire. Better than quoting the bottom of a coffee mug “Made in China”, which he did in another form later in that movie.

  3. Ollumi

    The only people I feel bad for are the Chinese employees who work at the Chinese offices of some of the said short sellers, not all listers have grown to see the world in sophisticated or, rather, structured ways.

    On the other hand, that’s a choice too.