The U.S. Government Accountability Office (GAO) issued a report last week recommending potential improvements to regulation safeguarding analyst independence.  The GAO concluded that current regulation is effective, but that the Securities and Exchange Commission (SEC) needs to review those aspects of the Global Research Analyst Settlement (GRAS) which have not been codified into regulation and decide which are warranted, if any.

A provision of the Dodd-Frank Act directed the GAO to examine the effectiveness of regulations implemented to address research analyst conflicts and suggest additional actions regulators could take.  The GAO reviewed academic literature, regulatory examinations and enforcement actions, as well as speaking with a variety of market participants, including four independent research firms (unnamed).

The 65 page report concludes that current regulation is generally effective, although noting that not all conflicts between investment banking and research can be eliminated and certain restrictions can be circumvented.  The findings were based on academic studies indicating improvements in stock recommendations, reduced levels of exam deficiencies and enforcement actions, reports from the independent consultants appointed as part of the GRAS, and commentary from market participants.

The GAO said that the Financial Industry Regulatory Authority (FINRA) has been working since 2008 to combine the regulations originally issued by its predecessors, the National Association of Securities Dealers and the New York Stock Exchange, into a consolidated rule, along with a few tweaks.  At the same time, FINRA has been working on rules applying to fixed income research.  The GAO report indicated that FINRA plans to integrate these initiatives with the goal of submitting a proposed rule covering both equity and debt markets to the SEC in the first half of this year.

According to the GAO, FINRA had no intention of having these rules supersede current GRAS regulation which is largely still in force for the investment banks which participated in the settlement.  The report therefore recommends that the SEC review those provisions of GRAS which are not incorporated in current regulation and decide whether those provisions should be included in the regulation that FINRA is preparing.  The SEC agreed with this recommendation, and is presumably acting upon it.

The GRAS provisions are more prescriptive in outlining information and organizational barriers between research and investment banking than current regulation and contain additional disclosure requirements.

Some in the independent research community had hoped for some continuation of the GRAS provisions requiring the distribution of independent research.  The GAO report does not include any recommendations along those lines, and includes no discussion of independent research.

At the other end of the spectrum, there are those who favor abolishing the GRAS provisions.  The GAO report offers little support for this either.

New York, NY – Despite the difficult market environment experienced by many independent research firms in 2011, institutional investors continue to find these boutique providers to be extremely valuable.  This view is based on the results of the 2011 All America Research Team announced by Institutional Investor Magazine in the fourth quarter of last year.  However, could recent market dynamics change these trends?

2011 AART Results

As you can see from the table below (click the table for a larger version), analysts at US independent research firms garnered twenty three (23) All-America Research Team (AART) rankings in 2011, a modest decline from the 26 seen in 2010, but slightly higher than the 20 analysts ranked in 2009.  In addition, analysts at 10 different independent research providers received II rankings in 2011, a slight drop from 2010 when analysts at 13 firms were ranked on the All-America Research Team.

Two independent research firms received II rankings for the first time in 2011, including Buckingham Research Group and Renaissance Macro Research.  Buckingham Research has been in existence for over 29 years, whereas Renaissance Macro is a new firm founded by well-known analyst Jeff DeGraff.

It is a little strange that five established independent research firms that received II rankings in 2010 did not obtain them in 2011.  These firms include Satya Pradhuman’s Cirrus Research, Bill Pecoriello’s Consumer Edge Research, Jim Furey’s Furey Research, Jeff Sprague’s Vertical Research Partners, and well-known Potomac Research.  This might reflect that boutique nature of these firms and their limited institutional sales resources rather than the popularity of their research with buy-side investors.

Longer-Term Trends Show Growing Acceptance

While independent research firms clearly experienced a modest dip in the number of analysts and firms that earned All-America Research Team rankings in 2011, it is still too early to tell if this performance reflects a change in the importance of boutique research to the buy-side’s research process.

Over the longer term we think Institutional Investor’s annual AART rankings reflect the growing acceptance of indie research by the buy-side.  For example, in 2000 only three independent research firms received a total of 12 II rankings (including ISI, Sanford Bernstein, and Schwab Washington Research Group).  This changed dramatically over the next ten years, so that by 2010, thirteen different independent research boutiques captured 26 II rankings (not including Sanford Bernstein who now provides investment banking services).

Could this Trend Reverse?

One of the reasons for the growing acceptance of independent research by the buy-side has been the willingness of well-known analysts to leave the sell-side and start their own indie research firms.  Certainly that has been the case over the past decade with former sell-side analysts Michelle Applebaum, Michael Goldstein, Dana Telsey, Ivy Zelman, Ed Wolfe, Satya Pradhuman, Jim Furey, Bill Pecoriello, Jeff Spague, and Jeff DeGraff establishing successful independent research firms.

Unfortunately, the extremely difficult market environment that many independent research firms have faced over the past few years could reverse analysts’ interest in leaving the sell-side and establishing their own independent research boutiques in the future.  Even worse, some independent analysts may look to move back to the sell-side.

While we have not seen any recent data to support this fear, it certainly warrants investigating.  One factor which could mitigate this development is the fact that many sell-side firms have experienced their own difficulties over the past few years.  In fact, we would not be surprised if shrinking Wall Street bonuses and recently announced layoffs don’t reduce the ranks of sell-side analysts in the coming months.  This could lead some analysts to consider joining independent research firms as an employment alternative.

New York, NY – Despite the difficult market environment for alternative research providers in 2011, one well-known former sell-side analyst – Carl Reichardt Jr. – decided to join independent researcher John Burns Real Estate Consulting last week as a new member of the management team.

The New JBREC Hire

Mr. Reichardt is joining John Burns Real Estate Consulting (JBREC) as their new Managing Director of Research, reporting directly to CEO and founder John Burns.  In this role, one of Reichardt’s principle duties will be to translate the research produced by the firm’s team of housing analysts so JBREC’s industry and buy-side clients can make best use of it.  Reichardt will also be opening JBREC’s San Francisco Bay Area office.

Reichardt was formerly a housing analyst for Wachovia / Wells Fargo Securities from 2003 to 2010. Previously, Reichardt worked at a private home builder for three years and at Montgomery/Banc of America Securities.  During his eight years with Wachovia / Wells Fargo, Reichardt was voted a member of the Institutional Investor All-America Research Team for three years, and he was a three-time recipient of the Wall Street Journal’s “All-Star Analyst” award.

Click here for more about this hire.

A Few Indies Pick Up Analysts from Sell-Side

As we have discussed recently, the alternative research industry has suffered a difficult few years as equity commission volumes have shrunk and the insider trading investigation has prompted nervousness among buy-side investors to use research produced by non-registered research providers.

However, a few indie research firms – like John Burns Real Estate Consulting – have seen this challenging market environment as an opportunity to add quality analysts to their team.  Another independent research firm which raided the sell-side in 2011 was Stamford-based Vertical Research Partners, a research firm started by II Ranked analysts Jeffrey Sprague and Nicole Parent.  Vertical added to their research team by hiring former sell-side analysts Robert Wertheimer, Chip Dillon and James Armstrong.

New York, NY – Over the past few years, bulge bracket firms have been losing research commission dollars to regional brokers, boutique investment banks, and independent research providers.  However, one surprising development which took place last year was that large investment banks experienced a reversal as they posted market share gains versus the alternative research industry.  One big question for 2012 is will bulge bracket firms continue to pick up share against their smaller brethren or will they resume their downward slide in the portion of the buy-side’s overall commission pool they receive for their research?

Market Share Gain for Bulge Research

According to Greenwich Associates’ 2011 U.S. Equities Study released last June, bulge bracket investment banks increased their share of institutional trading commissions to 68% in 2010 – 2011 from 65% in 2009 – 2010.  The portion of total institutional equity commissions that the buy-side allocated to bulge bracket research remained unchanged at 64%.

Overall, the buy-side paid 59% of their equity commissions to brokers for their research and advisory services in 2010 – 2011 – a ten year high.  This compares to 53% of equity commissions allocated to pay for research in 2009 – 2010.   This means institutional investors spent $6.8 bln on research in 2010 – 2011, down from $7.0 bln spent on research in the prior year.

Most analysts suggest that this increase last year occurred because the buy-side needed to allocate a higher percentage of their commission pool to pay for critical research services provided by bulge bracket firms as their overall commissions available shrunk.

Bulge Firms Might Maintain their Share

However, we suspect that bulge bracket firms and the sell-side in general, might be able to maintain their increased share of the research commission pool in 2012 for a variety of reasons.  This includes the following:

1. Continued Tight Commissions: Most professionals we speak to think that equity commission volume will continue to remain tight in 2012.  If this is the case, buy-side investors will need to allocate a relatively high share of commissions to pay bulge bracket firms for the research services they provide that is critical to the buy-side’s investment process.
2. Pickup in IPO Activity: Another valuable service that the sell-side provides the buy-side is access to the IPO calendar.  According to Renaissance Capital, IPO volume is expected to rise modestly in 2012 to 133 deals from 125 deals seen in 2011 (with Facebook being one of the likely 2012 IPOs).  Asset managers who want access to these IPOs will need to make sure they continue to pay their investment banks enough equity commissions to receive reasonable allocations.
3. Breadth of Coverage: Bulge bracket firms and other large broker dealers provide a breadth of coverage that becomes cost-effective for many buy-side firms due to the economies of scale that these larger firms possess.  Consequently, larger research users could actually pay more in total to a range of independent research providers than they would pay a smaller group of broad-based sell-side firms.  This becomes particularly relevant when commission dollars are scarce.
4. Insider Trading Fears: In 2011 many buy-side firms decided that the compliance risk of using broker-dealer research was considerably less than that of using alternative research (a view that we disagree with).  This led some institutional investors to focus their use of external research on sell-side firms.  If these concerns continue through 2012, we would not be surprised to see some buy-side firms continue to allocate more of their research commission dollars to sell-side providers versus indie firms.
   

Summary

As we discuss above, the market share gains that bulge bracket investment banks experienced in 2011 could well continue in 2012 for a number of reasons.  Such a development would bode ill for the alternative research industry as they will be forced to compete for the limited research commission pool that remains.  This trend could be exacerbated by move of some agency brokers to jump into the research business in order to increase the amount of commissions they can charge their buy-side clients.

One year ago, who would have guessed how deeply litigation and regulation would impact independent research?  Not us.  We were predicting that inside information concerns would abate in the second half of 2011.  Besides getting the duration wrong, we also did not foresee scope of concern, which broadened from inside information to confidential information, putting the mosaic theory to the test.  Here is a brief summary of the year’s compliance-related activity, with focus on the key themes.

1. Insider trading investigations turned into highly successful prosecutions. Since August 2009, Justice department attorneys under Preet Bharara have charged 56 people in insider-trading cases, of whom 52 have pleaded guilty or been convicted at trial.  Besides Galleon Group, former portfolio managers from SAC Capital and CR Intrinsic Investors LLC, an affiliate of SAC Capital, pleaded guilty.  We have had a lull in the investigations during the fourth quarter, although a Wall Street Journal article predicted in December that more indictments were pending, reportedly impacting an analyst at Neuberger Berman Group LLC and traders who worked at hedge funds Diamondback Capital Management LLC and Level Global Investors LP.

2.  Insider trading concerns spread to independent research firms. The FBI’s so-called “Investigation Matchmakers” focused on expert network Primary Global Research, which ceased operations after three employees, seven consultants and six clients pleaded or were found guilty.  Details here.  Peripheral players like John Kinnucan and Karl Motey who had their own research boutiques helped to broaden concerns beyond expert networks to other types of research providers.

3.  Confidential information is becoming as risky as material non-public information. Big Lots Inc. used the insider trading investigations as an opportunity to sue Retail Intelligence Group, a channel checker, for “wrongfully induced” information obtained from Big Lots’ store managers.  The suit was settled out of court, leaving market participants questioning where to draw the line on safe non-public information.  These concerns were exacerbated by the conviction of Primary Global Research salesperson James Fleishman after prosecutors focused on Fleishman’s involvement with confidential information rather than material non-public information.  Since obtaining confidential information is a easier case to prove (and a simpler infraction) than the materiality of inside information, the safe harbor afforded by mosaic theory is weakened.

4. Anti-bribery statutes became a concern. The broad language and aggressive enforcement of the U.S. Foreign Corrupt Practices Act generated concerns for international research providers, particularly in China where many enterprises are government-affiliated.

5.  Insider trading regulation spread to non-equity markets. Regulators have periodically brought inside information cases relating to fixed income markets, most recently in 2009.  The Dodd Frank Act extended insider trading sanctions to futures and swaps markets.

6.  Regulators brought actions against broker dealers for faulty insider trading compliance practices.  The SEC fined Janney Montgomery Scott and FINRA fined Midtown Partners & Co. LLC for allegedly having inadequate insider trading compliance.

7.  There is increasing scrutiny of political intelligence research. The Stop Trading on Congressional Knowledge Act, or STOCK Act, which would prohibit Members of Congress and federal employees from profiting from nonpublic information obtained new life after it was featured by 60 Minutes.  The House version of the legislation requires registration of political intelligence research firms.

8.  Quantitative models received regulatory actions. The SEC instituted administrative proceedings against three AXA Rosenberg entities for inadequate oversight of quantitative research models.

9.  The SEC reviewed trading ideas platorms. The SEC conducted a series of ‘sweeps’ focusing on whether ‘alpha capture’ platforms violate sanctions against selective disclosure of research.  The probe was prompted by  Goldman Sachs’ practice of providing favored clients advance notice of potential research actions as part of its ‘trading huddles.’  Goldman paid a $10 million fine to Massachusetts and agreed to end its practice.  The SEC has taken no action with alpha capture platforms.

10.  Challenge to management access. EuroIRP, the European trade association of independent research providers, issued  a report arguing that management access does not meet the European definition of research and should not be payable through commissions.  The report also suggested that the U.S. insider trading investigations may lead to greater regulatory scrutiny of corporate access.  As far as we know, this has not happened.

ConvergEx Inc., a trading-software company partially owned by Bank of New York Mellon Corp., announced last month that its July agreement to be bought by CVC Capital Partners Ltd. was terminated amid regulatory investigations of its Bermuda unit.

According to Convergex, investigations by the U.S. Securities and Exchange Commission and the Department of Justice mainly involve certain non-electronic trade-execution practices by a Bermuda-based ConvergEx Global Markets unit, which was expected to produce 7 percent of revenue in 2011.

Convergex said it was conducting an internal review as the audit and risk committee of the board hired outside counsel.

CVC Capital Partners, a London-based buyout firm that oversees a 10.8 billion-euro ($14.1 billion) fund, would have become the largest owner of ConvergEx under the deal announced July 20. The buyout may have been valued at $1.9 billion.

ConvergEx posted revenue of $610 million in 2010 and earnings before interest, taxes, depreciation and amortization, excluding certain items, of $162 million. The company, which sells software to handle trading and risk management, also functions as a broker-dealer. Westminster Research Associates and Convergex, which are prominent in the commission management space, are subsidiaries.

In May, Convergex had filed with the SEC to raise as much as $400 million in an initial public offering.

Environment

Last January, we predicted that 2011 would be a tough year for the research industry, and particularly for independents.  We understated the case.  At the Investorside Member’s Day meeting in April, participants said the three key challenges were sales and distribution, payments, and compliance, all of which continued to be laments throughout the year.

Greenwich Associates reported U.S. equity commissions declined 12% to $11.6 billion for the period from mid-February 2010 to mid-February 2011.  The Tabb Group forecasted a 17% decline in commissions during calendar year 2011.  Tabb predicted commissions would fall to $7.25 billion by year end.

Greenwich said that bulge firms were gaining share, receiving 68 percent of U.S. equity commissions, up from 65 percent in their 2010 survey.  Agency brokers were squeezed as the portion of commissions allocated to research climbed to a 10-year high of 59%, the result of investors maintaining research relationships in the face of declining commissions.  For similar reasons, commissions allocated to pay for corporate access increased to 21%.

The percentage of U.S. asset management firms using CSAs increased to 76% from 65% in 2009 according to the Tabb Group.  However, volumes going through CSAs remained flat around 22%.  Tabb also reported consolidation in the number of CSA brokers used.

According to Challenger, Gray & Christmas, financial services firms announced 56,191 job cuts through November, an increase of 162% from 21,430 layoffs in 2010.

Mergers & Acquisitions

We saw many mergers and consolidations during 2011, and expect this trend to continue into 2012.  Given the environment in 2011, we suspect there are more deals to come.

In February, Ticonderoga Securities LLC purchased Soleil Securities Corp.  Terms were not disclosed but were rumored to be negligible.  Alpha capture platforms First Coverage and youDevise Ltd merged in March and the combined entity was renamed the TIM Group.

In May, Forrester Research, Inc. acquired Springboard Research, a Singapore-based provider of IT industry research for $9 million cash less certain holdbacks and earn-outs, representing a multiple of around 1.6x revenues.  Business Connect China, a China-based expert network, merged with Evalueserve’s Circle of Experts and Tribeca Insights to form a new consolidated expert network, Advantus Global.

In June, Investment Technology Group (ITG) announced its acquisition of Ross Smith Energy Group for $38.5 million in cash, representing a 2.6x multiple on Ross Smith’s prior year revenues of $15 million.  Citic Securities, China’s largest investment bank, acquired 19.9 percent of Credit Agricole SA (ACA)’s brokerage units, CLSA and Credit Agricole Cheuvreux, for $374 million.

Also in June, Euromoney Institutional Investor PLC announced its acquisition of Ned Davis Research Group a prominent strategy research firm for a maximum price of $173 million including earnouts. The maximum purchase price was approximately 14.7 times Ned Davis’ 2010 pre-tax profits and estimated 2.5 to 3.0 times revenues.

In July, CVC Capital Partners, a private equity firm, announced it was planning to acquire ConvergEx Group, parent of Westminster, in an all cash transaction of $1.9 billion but dropped the deal in December because of  investigations by the U.S. Securities and Exchange Commission and the Department of Justice into  certain non-electronic trade-execution practices by the Bermuda-based ConvergEx Global Markets subsidiary.

In August, equity research firm Sabrient Systems acquired the forensic research portion of Gradient Analytics, including the use of the brand “Gradient Analytics.”  Bloomberg, L.P. announced the largest acquisition in the company’s 30-year history with a $990 mln bid for BNA, a privately owned legal, tax and regulatory information company originally known as the Bureau of National Affairs.

In September, State Street Corporation purchased Pulse Trading, a Boston-based agency broker, which also markets independent research services to its buy-side clients.

In October, CNBC reported that Roubini Global Economics was for sale with projected 2011 revenues of $14 million and a net loss of $2 million.  No transaction has been announced.

In November, Washington Research Group, a prominent policy research firm orphaned by the demise of MF Global, found a new home in Guggenheim Partners.  Markit, a financial information provider best known for its CDS data, purchased Quantitative Services Group (QSG), an independent research providing equity research and trading analytics.

Also in November, Gerson Lehrman Group (“GLG”), the leading expert network, made a minority investment in Shanghai-based Ushi.com, a Chinese version of LinkedIn as part of a $3 million funding round.  Moody’s Corp. acquired a majority stake in Copal Partners, a $50 million research outsourcing firm, for an undisclosed sum.

WJB Capital Group Inc., an agency broker which distributed third party research, shut its brokerage operations yesterday.  According to research firms distributed by WJB, they were notified about the closure yesterday, and scrambled to reassure mutual clients.

WJB had over $8 million of subordinated debt, including $1.35 million due last month, according to a 2010 annual report with the U.S. Securities and Exchange Commission. The firm reported net income of about $221,000 in 2010 on revenue of $45.9 million, according to the annual report.

WJB Capital was “unable to raise capital in a manner that would have allowed the firm to continue its operations given the current climate and the constraints that would have been placed on everyone,” Chief Executive Officer Craig A. Rothfeld said in an interview with Bloomberg. The New York-based firm shut voluntarily, he said.

WJB offered a dedicated corporate access team, research on macro investment strategy, technical analysis and derivative strategy, in addition to distribution of third party research from Cardinal Research LLC, JRPG Investment Research, John Burns Real Estate Consulting, Market Advisors and in the past Strategas and Blue Phoenix Inc.  The company announced new hires as recently as last month with four new equity analysts, including Bryan Maher and John Newman from Citadel Securities LLC, according to a Dec. 8 statement.

Declining commissions has created an adverse environment for agency brokers.  Average daily equity-trading on major U.S. exchanges was about 7.8 billion shares in 2011, a 20 percent drop from 2009, according to data compiled by Bloomberg.

WJB Capital was founded in 1993 by two agency brokers on the floor of the New York Stock Exchange, and expanded from 10 employees to more than 100 in the past 10 years.

Click here for the Bloomberg article on WJB Capital’s closure.

New York, NY – In 2011 it became clear that US federal authorities had started the widespread use of telephone wiretaps to investigate and prosecute insider trading among hedge funds, industry consultants, and expert networks.  Now, the SEC has started employing quantitative analysis to identify hedge funds, mutual funds and private equity firms that might be perpetrating fraud based primarily on performance that seems too good to be true.

Aberrant Performance

It is clear that the criticism that the SEC has faced for failing to identify the Bernie Madoff scandal has had a profound effect on the way the government is attacking securities fraud in the hopes that another such case does not slip through the cracks.

In 2009 the SEC started the development of a computerized system called its “aberrational performance initiative” which currently analyzes the monthly performance data on thousands of hedge funds in search of firms whose performance seems out of the ordinary.

This system doesn’t just flag firms’ whose performance is consistently better than other similar type funds.  It also identifies funds whose returns remain strangely stable even in the face of severe market volatility.  The results of the “aberrational performance initiative” has led the SEC to identify 100 hedge funds which it feels warrants additional investigation.

Based on the initial results of this initiative, the SEC is expanding it to include mutual funds and private equity firms.  Consequently, the SEC expects to be analyzing monthly performance data on over 20,000 hedge funds, mutual funds, and private equity firms.

Wall Street Response

Identifying potential fraud cases based on fund performance isn’t popular within the financial services industry, as some investment managers are worried they might get caught up in an investigation simply because their numbers are better than their peers.  In fact, some argue that such an initiative might have a chilling effect on investment managers who are legitimately doing a good job for their investors.

However, the SEC argues that it does not rely solely on an analysis of a fund’s performance to bring a case.  According to Robert Kaplan, the co-chief of the SEC Enforcement Division’s Asset Management Unit, after the SEC runs its quantitative assessment of hedge fund and mutual fund performance, it does a qualitative evaluation of suspicious looking firms to determine if their performance can be explained or if further investigation is warranted.

Early Results

So far, the results of this new initiative must seem encouraging for the SEC.  In December 2011, the agency announced four civil-fraud lawsuits against various fund managers including ThinkStrategy, LeadDog and Solaris Management LLC based on this analysis.

In the case of ThinkStrategy, the SEC alleges the firm’s founder engaged in deceptive conduct in an effort to raise their “track record, size and credentials.”  This included claiming the firm generated returns of 4.6% in 2008 when the average hedge fund fell roughly 19%.  The SEC claims that ThinkStrategy’s real return for the year was a loss of 90%.

The SEC alleges that LeadDog Capital Markets’ owners Chris Messalas and Joseph LaRocco induced investors to invest in a hedge fund they controlled through material misrepresentations and omissions about a number of issues, including (i) Messalas’ negative regulatory history; (ii) Compensation received by Messalas and LaRocco in connection with the fund’s investments; and (iii) Messalas’ substantial ownership interest in some of the companies to which he directed fund investments.

Solaris Management operator Patrick Rooney is charged with fraudulently misusing fund assets.  According to the SEC’s complaint, Rooney allegedly misused the Solaris Fund’s money by investing over $3.6 million in Positron Corp. through both private transactions and market purchases contrary to the fund’s offering documents and marketing materials.  Positron Corp. is a financially troubled microcap company of which Rooney has been Chairman since 2004.

Changing Tactics

It is clear to us at Integrity Research that the government’s use of wiretaps in investigating and prosecuting insider trading, and the SEC’s recent development of its “aberrational performance initiative” to identify potential fraud at hedge funds, mutual funds and private equity firms marks a significant change in the way regulators intend to fight white collar crime.

In a statement, Robert Khuzami, Director of the SEC’s Division of Enforcement explained this shift by saying, ”We’re using risk analytics and unconventional methods to help achieve the holy grail of securities law enforcement — earlier detection and prevention.  This approach, especially in the absence of a tip or complaint, minimizes both the number of victims and the amount of loss while increasing the chance of recovering funds and charging the perpetrators.”

In other words, criminals beware.

New York, NY – Silvercorp Metals, Inc., a Vancouver-based company with mining operations in China, has decided to fight back against accusations from short sellers of accounting fraud.  Last week, this battle intensified as Chinese law enforcement officials have opened a criminal investigation into anonymous parties including IFRA, Alfred Little and others for creating “false and fraudulent reports” attacking Silvercorp Metals Inc. and its Chinese subsidiaries.

Criminal Investigation Launched

Silvercorp is the largest primary silver producer in China with four silver-lead-zinc mines at the Ying mining camp in Henan Province.  The company is based in Vancouver, Canada and trades on the Toronto and New York Stock Exchanges under the ticker SVM.

Last week, Silvercorp announced that Chinese investigators have opened a criminal case against the numerous creators of “false and fraudulent reports” attacking Silvercorp Metals Inc., including IFRA, Alfred Little and others.

The company has been told not to disclose too much about the investigation.  Silvercorp’s chairman and CEO, Rui Feng explained, “I cannot tell you exactly where it is,” but “it is more than one police department,” he said.  “They asked us to provide all the information we have collected, which we did.”

A potentially interesting aspect to this case was mentioned in Silvercorp’s Press Release announcing the criminal investigation.  Silvercorp alleges that in November it had received a number of calls from hedge funds, including one call from an expert network – Guidepoint Global – trying to find a mining engineer who worked for the firm who would speak to a hedge fund manager.  The Press Release suggests that the engineer was offered a bribe to “attain insider information on Silvercorp for trading”.

Click here to read Silvercorp’s Press Release in its entirety.

Background on the SVM Case

The criminal investigation is just the latest phase of an ongoing battle between Silvercorp and a group of short sellers.  On August 29^th, 2011 an anonymous letter was sent to the Ontario Securities Commission, Silvercorp’s auditors and various media outlets accused the company of a $1.3-billion accounting fraud.

In early September, the short sellers argued in anonymously authored reports published on Alfredlittle.com that Silvercorp must be overstating its earnings by at least five times based on the financial statements filed by a joint-venture partner.  In addition, these reports called into question Silvercorp’s mining operations and asset transactions.  The accusations prompted a sharp selloff in SVM.

Later that month, Silvercorp brought a lawsuit in the New York County Supreme Court against “Chinastockwatch.com, Jerry Katz, Alfredlittle.com, Alfred Little, Simon Moore, and several ‘John Doe’ defendants for spreading ‘false, defamatory and fraudulent’ information about Silvercorp on the Internet and in letters to the media and regulators”.  Two separate legal actions have been brought in this matter in British Columbia.

In October, Silvercorp reported that the results of an investigation conducted by KPMG Forensic Inc. – hired by Silvercorp’s board – found that the revenue reported in the financial statements filed with the United States Securities and Exchange Commission was “substantially correct”.  In addition, KPMG found that its statements on cash and cash equivalents were accurate.

Summary

The Silvercorp case is the latest example of a company with Chinese operations being charged with accounting fraud by short sellers who published their findings in a research report.  Earlier this year, Muddy Waters accused Sino Forest of overstating its revenues and running “a massive Ponzi scheme”.  While the Toronto-listed company is fighting the allegations, the firm’s share price plunged more than 70%, and it has ceased trading on the TSX.

The big difference between the Sino Forest and Silvercorp cases is the aggressiveness with which the management of the companies responded.  In the Sino Forest case, they took over five months to hire an independent committee to investigate the charges and release its report in favor of the company.  This took Silvercorp a little over one month.  In addition, Silvercorp brought multiple lawsuits against the short sellers who published the reports within a very short period.

While it remains to be seen whether the accusations against Sino Forest or Silvercorp are accurate, it is clear to us that public companies need to respond quickly and decisively when they are attacked so openly by short sellers.