August 7, 2017 / 12:03 AM / in 4 months

As short sellers target Chinese companies in Hong Kong, hostility mounts

HONG KONG (Reuters) - Short sellers are increasingly targeting Hong Kong-listed Chinese companies they allege have committed accounting tricks, market manipulation and fraud. And that’s despite mounting hostility faced by investors who bet against stocks.

FILE PHOTO: (L-R) The Hong Kong Exchanges flag, Chinese national flag and Hong Kong flag are hoisted outside the Hong Kong Stocks Exchange in Hong Kong June 7, 2016. REUTERS/Bobby Yip/File Photo

This year, there have been nine campaigns by short sellers against Hong Kong-listed companies as of mid-July, a record for the period, according to data from Activist Insight. This time last year there had been only two and in 2015 six. Short sellers said increasing capital flows between mainland China and Hong Kong, spurred by Beijing’s recent moves to open up its equity markets, were exacerbating corporate governance problems in Hong Kong.

“We suspect the increased capital flows between the mainland and Hong Kong have encouraged more stock manipulations and frauds in Hong Kong,” Carson Block, founder of Muddy Waters and among the most prominent short activists, told Reuters in an email.

But calling out these frauds is not for the faint-hearted. Those betting against companies encounter a bitter response from their targets, as well as from the shareholders in those companies and from the Chinese authorities. The short sellers say the backlash can come in the form of litigation, smear campaigns, arrests, hacking of their information, surveillance, physical assault and death threats - against them, their staff and even their families.

Dan David, the 48-year old co-founder of U.S.-based short activist GeoInvesting, says he has received emails detailing how he might die, has been the target of multiple attempted hacks, sued three times unsuccessfully, and confronted in his driveway by an angry investor.

”People would rather make money on a fraud than lose money on the truth,” said David, who unveiled his most recent campaign against food manufacturer China’s Dali Foods Group 3799.HK in June.

David claims the company has implausibly low expenses and salary costs, while its tax filings display troubling inconsistencies. The company has denied the allegations, which it says are misleading and based on selective information. SMALL PUBLIC FLOATS The short sellers borrow stock in a company and then sell it to take a short position – their hope being that they can buy the stock back at a lower price and close out the position at a profit.

(For FACTBOX showing companies targeted:)

David and other short sellers focused on mainland Chinese stocks listed in Hong Kong say that poor regulation, weak enforcement and small public floats means there are more stocks overvalued in the territory than in other major markets.

China’s strict investment rules make it all but impossible to take short positions in individual domestic-listed Chinese stocks from overseas.

Some companies may have used accounting tricks to overstate their profitability, or have over-promised – perhaps they have a fad product whose popularity will fade quickly.

Critics say short sellers are cynical opportunists who destroy shareholder value for their own gain. The shorts counter by saying they are a force for good, going to great lengths to expose fraud and persistent problems with listing and governance standards in the city.

In June, Christopher Cheung, who represents financial services and business interests in Hong Kong’s legislative chamber, called on Hong Kong’s Securities and Futures Commission to more tightly scrutinize short sellers, saying they had caused “serious disturbance to market order” in Hong Kong and hurt investors.

In a statement, an SFC spokesman said: “The SFC considers that responsible research can all contribute to the overall market quality and price discovery process and has no intention to suppress legitimate commentaries on listed companies, whether positive or negative.”

Though less prominent than peers such as Block, David - who is also chief investment officer of hedge fund FG Alpha - has been seeking to expose dodgy dealings at Chinese companies listed outside the mainland since 2010.

He typically sets to work screening for a range of tell-tale signs, including auditors, brokers and investment banks that have a track record of working for questionable companies.

Some firms, such as Asia-based Blazing Research, also solicit tips and will pay “handsomely” for useful information, it told Reuters in an email.

Many firms hire private investigators to review a company’s operations in China. They can spend months pulling business registrations, poring over tax filings, counting truck traffic or point of sale terminals (sometimes after installing cameras), appraising land claims, and quizzing nearby residents. They are often looking to see whether the reality on the ground matches executives’ statements.

RESEARCHER DETAINED

But such tactics can backfire. On one occasion, a member of David’s team was beaten-up by security guards who spotted him counting trucks driving in and out of the company’s factory. Sometimes it is worse than that. AlfredLittle.com’s researcher Kun Huang, a Chinese-born Canadian, was convicted of criminal behavior and jailed in China for two years and then deported.

David and Block have also received anonymous threatening emails. One received by Block in 2010 mentioned his wife Kathy, asking: “Are you, Kathy and your dad ready for a bullet?” Block moved to California the same year and now minimizes his time in Hong Kong, which he said is becoming a riskier environment for short sellers because of Beijing’s increasing influence in the former British colony.

As Chinese companies grow savvier to short tactics, betting against them has become riskier. They are faster to rebut allegations and they also more often openly attack the short sellers’ credibility, making for more drawn-out, expensive campaigns.

They will call on large shareholders or friendly funds and brokers to help prop up the share price or to suck up the supply of borrowable stock, making it more expensive to cover short positions.

“Some Hong Kong stocks have a very limited public float, making it easy for the controlling shareholder to prop up the share price even though the company is indeed fraudulent,” said Blazing Research in an email.

It is unclear if Block made or lost money on his December campaign against China Huishan Dairy 6863.HK after the company quickly halted its stock and announced the chairman was increasing his stake. The share price subsequently rose and stabilized until plummeting 85 percent on March 24.

”Being right and making money are two different things. Most of the time they do intersect for us, but not all of the time,” said Block in June.

Reporting by Michelle Price; additional reporting by Elzio Barreto and Twinnie Siu in Hong Kong; Editing by Martin Howell

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