Short-Sellers' Hunt for Fraud Shifts to Hong Kong

Article Reuters

They are victims of their own success. So now it's time for short sellers of Chinese stocks listed in North America to shift their attention thousands of miles away to Hong Kong.
Short-selling investor-bloggers have made enough noise, and cash, by shorting the shares of New York and Toronto-listed Chinese companies and issuing reports accusing them of fraud that the charges for borrowing shares in these companies has soared. And that can make the strategy's costs prohibitive.

They have also picked off the low-hanging fruit - the companies, most of which came to the U.S. market through reverse takeovers (RTOs), that have committed the most obvious accounting shenanigans.

There is therefore an increasing danger the short sellers will overstep by accusing healthy Chinese entities in the U.S. of misbehaving and face legal action from the companies or the authorities as a result.

"This is no longer an easy game. We're moving on from the Chinese RTOs. They've been beaten to smithereens by this point. The game is getting harder and no longer in the U.S., but rather is moving to Hong Kong," said John Hempton, a short seller of Chinese companies as the chief investment officer of Sydney, Australia-based Bronte Capital Management.

Through an RTO, a company merges with a shell company that already has a listing on a U.S. exchange as a way of gaining access to stock market investors more quickly and cheaply than through the more arduous process of an initial public offering.

Additional investor interest in the problems in the sector has not only increased the borrowing demand for shares to short and reduced their availability, but the spectacular plunge of some company share prices has brought down values, making it harder to find profitable trades, fund managers say.

There have been over 20 U.S. listed Chinese companies delisted or halted so far this year amid the allegations, while others have been hit by the resignation of their auditors.

Among the most notable to have suffered from such negative hits are Rino International (RINO.PK), China Media Express (CCME.PK), and Longtop Financial Technologies Ltd (LFT.N).

However, there have been occasions where shares have quickly bounced back after initially sinking on reports thy have been targeted by the short sellers.

COSTS RISING

An investor who hones in on a company believed to have provided fraudulent information and wanted to short the shares used to be able to borrow those shares at less than 1 percent a year.

"Costs are now up to anywhere between 7 to 70 percent," said Andrew Left, a Beverly Hills-based blogger and short seller who runs Citron Research. In some cases it is higher, perhaps even 100 percent.

Short sellers bet on a decline in a stock by borrowing shares in the market and selling them in the hope they can buy them back once prices have dropped. They would then return the shares to the owner and keep the difference as profit.

Carson Block, the director of research at one of the most prominent short selling firms, Muddy Waters, told Reuters in an email that the increasing inability to borrowing shares has made it more difficult to commit capital and resources to research into companies it suspects of fraud.

"It is far more difficult to short these days. It takes 100 percent of your margin buying power to borrow here and quite frankly some of the other exchanges haven't caught up with what we've dealt with the past 8 months," said Dan David, head of sales and daily operations at research and investing firm Geo Investing in Skippack, Pennsylvania.

"We are trading other exchanges, that's very much a recent development," he said.

SHORT INTEREST GROWS

The Hong Kong authorities have indicated that they think many of the recent problems have been because of loose listing standards in the U.S. In Hong Kong, for example, companies seeking listings have to have a track record of profitability that they aren't required to have in the U.S.

Indeed a source close to Hong Kong regulators dismissed the notion of widespread problems in that market, saying that the U.S. Securities and Exchange Commission "has acknowledged there's a problem with the way some of these companies have been able to list in the U.S., which wouldn't happen in Hong Kong."

Hempton doesn't buy this argument, though.

"It's the simple facts on the ground that make Hong Kong attractive - lots of large market caps and lots of frauds. The first Chinese forestry company that got pinged faking their ownership was in Hong Kong, not Canada," said Hempton.

Hempton was referring to China Forestry Holdings (0930.HK), whose shares were suspended in January of this year after auditor KPMG informed the board of directors of possible irregularities in its accounting books and its former CEO faced investigation by authorities.

More recently shares in another forestry concern, Toronto-listed Sino-Forest (TRE.TO), plunged leading to more than $4 billion of market value being lost on accusations of fraud that are denied by the company.

Singapore is also increasingly a fertile ground for those wanting to dig up accounting problems at Chinese companies.

On Thursday, the Singapore Exchange reprimanded Chinese multimedia firm KXD Digital Entertainment (KXDD.SI) and its former chairman and CEO Liu Fusheng for breaching a string of rules, including failing to disclose it had ceased business operations. [nL3E7HU0FF]

The same day, China Gaoxian (CGXF.SI) said its special auditor had obtained evidence showing its cash and bank balance at the end of last year was around 93 million yuan ($14 million), not 1.1 billion yuan which the fabric maker had originally claimed. [nSNZ1x9f9w]

Certainly, the figures are starting to support the talk of the beginnings of a shift in interest by short sellers.

Short interest, that is shares in a company being sold short as a percentage of the total number of shares outstanding, is rising on the Hong Kong Stock Exchange while it has slipped from a recent peak for U.S. listed Chinese companies, according to New York-based research firm Data Explorers.

Year-to-date, average short-interest among Chinese companies listed in the U.S. has doubled to 5.8 percent in the past six months, though it is off a recent peak of 6.7 percent.

Short interest in Hong Kong listed shares is considerably lower, but has risen to 1.34 percent from 0.81 percent around the end of last year, the firm said.

"The trend is identical, just not as aggressive, and that's probably related to fewer hedge funds based in Hong Kong," said Will Duff Gordon, research director at Data Explorers.

Gordon speculated it was unlikely many retail investors would switch their focus to Hong Kong from U.S. markets.

"There has been an uptick in Hong Kong short interest generally, but that could be related to wider macro issues," he said.

There has been increasing concern in the past year that China's economic boom could turn to a bust, particularly because of the possibility of a real estate bubble. Beijing has made efforts to slow down the pace of economic growth in an effort to short-circuit speculative investing and inflation.

"Rising short interest in Hong Kong could be a macro issue, but I think some of these investors and research firms in the U.S. have now developed an expertise and given the scrutiny here, it would make sense for them to apply their skills to places like Hong Kong," said Sahm Adrangi, principal owner at New York-based Kerrisdale Capital Management.

Iranian-born Adrangi's firm has a staff of five managing about $20 million in assets. He confirmed published reports that first quarter performance rose 73.2 percent, due mostly to shorting U.S.-listed Chinese companies accused of fraud.

However, rules in Hong Kong could throw up barriers to firms such as short selling research firm Muddy Waters if they don't have a license to offer advice on listed companies.

Block, in his e-mail, said this issue comes down to what extent there are protections for free speech to discuss a stock.

And not every investor is ready to bet against Hong Kong-listed companies.

"There is a witch hunt going on. They're going to find some companies (in Hong Kong) and I think it will be good in the long term for investors," said Himanshu Shah, president and chief investment officer of Shah Capital, a $300 million hedge fund in Raleigh, North Carolina.

Shah, who said his firm is mostly long China, said the country is moving in the right direction.

"It's not going to be accomplished overnight or in a quarter; the cleansing of corporate China has begun for sure." (Additional reporting by Rvan Vlastelica, David Gaffen in New York and Rachel Armstrong in Singapore. Editing by Martin Howell)