Potential Bias Clear with Muddy Waters


New York, NY – Over the past year or so, New York-based research provider, Muddy Waters Research has identified a number of Chinese companies which it believes have committed fraud, including Sino Forest and most recently Focus Media Holdings Limited.  Muddy Waters’ research reports have had substantial negative impacts on the values of the companies in question as short sellers have punished these stocks.  However, Muddy Waters’ own position as a short seller makes it clear that its own research could potentially be biased.

Research Could Be Accurate

We must be clear – we are not saying that Muddy Waters’ research has been inaccurate.  It has not been proven whether their research is correct or not.  Unfortunately, that has not really mattered as short sellers have used these reports as an excuse to batter these companies’ shares based on Muddy Waters’ growing track record of uncovering other Chinese companies with questionable financial practices.

On November 21, 2011 Muddy Waters alleged in its research that Shanghai-based Focus Media overstated the number of screens in its LCD network by 50% and that it significantly and deliberately overpaid for acquisitions, writing down $1.1 billion out of $1.6 billion in acquisitions since 2005. Focus Media’s share price dropped 39% on the first day following the release of the Muddy Waters report.

In June, 2011 Muddy Waters reported that Sino-Forest Corp. had overstated its assets and revenue, calling it a “pump and dump” scheme that has been “aggressively committing fraud.”  The Toronto-listed company’s share price plunged by more than 70% as a result.  An investigation completed and released a few weeks ago by an independent committee supported Sino-Forests’ assertions denying wrongdoing.  The company remains under investigation by the Ontario Securities Commission.

In February, 2011 Muddy Waters’ said that China MediaExpress had significantly inflated its revenue and profits in order to enrich management through earn-outs and stock sales.  Muddy Waters estimated that CCME’s actual 2009 revenue was no more than $17 million versus the $95.9 million it reported.  Deloitte & Touche eventually resigned as CCME’s auditors and the firm was de-listed from the NASDAQ.

In November, 2010, Muddy Waters, in its second research report, skewered Dalian Rino Group with a “Strong Sell” based on accusations of malfeasance for overstating revenue and diverting “tens of millions” of dollars for “its own use.”  This culminated with Nasdaq delisting its stock, and the company admitting it had not entered into two contracts which were questioned by Muddy Waters. The board has since cautioned investors that its financial statements dating back to 2008 should be no longer relied upon.

Obvious Conflicts of Interest

Unfortunately, Muddy Waters’ business model has been the main reason that the objectivity of their research has been called into question as it is rife with conflicts of interest.  Muddy Waters’ clients do not pay a fee for its research, instead they get this research free of charge.  Muddy Waters is a “short seller” who benefits commercially by taking positions based on its research – often before it distributes this research to others.  The following is an excerpt from the firm’s research disclaimer which explains this arrangement.

“You should assume that as of the publication date of any report or letter, Muddy Waters, LLC (possibly along with or through our members, partners, affiliates, employees, and/or consultants) along with our clients and/or investors has a short position in the stock (and/or options of the stock) covered herein, and therefore stands to realize significant gains in the event that the price of stock declines. Following publication of any report or letter, we intend to continue transacting in the securities covered therein, and we may be long, short, or neutral at any time hereafter regardless of our initial recommendation.”

Muddy Waters’ primary purpose for distributing their research to other investors is to convince them to also short the stocks they have already taken short positions in themselves.  Some might argue that Muddy Waters could have a financial incentive to exaggerate or potentially fabricate information about the companies they cover as the firm only profits when the shares of the stocks they write research on fall in price.

Use At Your Own Risk

Clearly, Muddy Waters’ research has contributed to making some investors rightfully wary of investing in Chinese companies given the purported financial fraud that the firm has identified at little-known Chinese companies listed in the U.S..  However, the conflicts of interest inherent in Muddy Waters’ own business make it unclear whether the firm’s allegations are the results of objective research or are financially motivated.  The following sentence from Muddy Waters’ disclaimer puts this conundrum in perspective.

 “Use of Muddy Waters LLC’s research is at your own risk. You should do your own research and due diligence before making any investment decision with respect to securities covered herein.”

 Unfortunately, Muddy Waters’ own business model has led to a lack of clarity on the reliability of its research.


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