On November 21, management at Nasdaq-listed Chinese company Focus Media received news a firm in its position doesn’t expect to hear: it was the subject of a "strong sell" recommendation and research report by Muddy Waters.
Shares in FMCN fell almost 66%, before closing a wrenching 39% down by day’s end. Research firms such as Muddy Waters identify companies they think are mis-stating revenues or otherwise misleading the market, short the stock, and then go public with their accusations and watch the shares plummet.
So far their track record has been good: although some targeted companies have managed to restore partial credibility, these research firms have exposed genuine fraud and poor corporate governance in many foreign-listed Chinese companies, as well as loopholes in the listing process that allows them to do it. Much discussion has centred on the vetting that regulators, accountants, stock exchanges, underwriters and investors themselves should have done.
But it is also important that the publishers of these reports themselves be held to a standard of accountability. Capital markets bankers in Hong Kong – admittedly with a vested interest in curbing the activities of short-sellers whose reports can tank the stocks they bring to market – are alarmed by the tone and content of these reports.
The Muddy Waters report on Focus Media contains a level of innuendo, inflammatory language and under-supported accusation that a report published in other circumstances – say, by a financial magazine – would struggle to get away with. The company is compared to disgraced Japanese camera maker Olympus, as if to heap the sins of the latter on the former. The report is filled with speculation: for example, "this [accounting imbalance] may be another sign of cooked books". There are many jokes, sarcastic footnotes, and punning swipes at the company’s subsidiaries’ names.
That’s not to say the arguments in the report are false. But it is alarming to see some 40% of the company’s market value slashed in one day, based on one openly front-run report. Focus Media has said that Muddy Waters failed to understand its business, rebutting several of the report’s specific allegations with new evidence. But even if it were to vindicate itself the damage might already be done. Many of these US-listed Chinese stocks are poorly traded and covered: once they go down, they might never come back up.
Some lawyers say that going after the short-selling firm might be missing the point: claimants tend to go where the money is, which might mean the accounting firms and investment banks that signed off on the listings. Other sources defend the research firms’ exposure of poor corporate governance and outright fraud, and say that it is up to investors as always to protect themselves. Nonetheless, the outcome for the subject of one of these reports can be death in the public markets whether fraud is present or not.
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