On the surface, it appears to be an underhanded way to make money at the expense of other investors: take a short position (sell borrowed shares) in a company, trash it in an anonymous blog and then cash in when the share prices drop.
That’s what Jon Carnes of Eos Funds did back in 2011, when he used a fake identity to post detailed, critical analyses of the Ying silver mine owned by Vancouver-headquartered Silvercorp Metals Inc. (TSX, NYSE:SVM).
On September 13, 2011, the same day Silvercorp was presenting at an investor conference, Carnes published the first in a series of damning reports on his alfredlittle.com blog.
Silvercorp’s shares dropped 20% in one day, and its market cap fell by $288 million. Carnes netted $2.8 million when he closed his short position on Silvercorp.
“The release was timed to create the most possible damage for Silvercorp,” the BC Securities Commission (BCSC) said in hearing documents.
Silvercorp’s share value has declined steadily ever since, and the company has spent millions on lawsuits.
It lost its bid to sue Carnes and other short-sellers for defamation in the United States before agreeing to a US$14 million out-of-court settlement, after U.S. shareholders launched a class action against the company based in part on Carnes’ and other short-sellers’ research.
While a BCSC panel described Carnes’ shorting and reporting to be “self-serving” and “unsavory,” it recently dismissed all allegations of securities fraud against him.
“I’m relieved to see that they found me not guilty of violating these securities laws,” Carnes said. “At the same time, I don’t agree with any of their findings that I acted in any way improper.”
So is Carnes a self-serving short-seller who cost Silvercorp and its shareholders millions in order to line his own pocket? Or is he a whistleblower whose own due diligence exposes companies that are, at best, overvalued or, at worst, outright frauds?
Carnes’ track record lends some weight to the latter.
A successful investor, Carnes, who lives in Vancouver, founded Eos Funds, which specializes in investing in Chinese companies that are publicly listed on North American exchanges.
In recent years, several of those companies have been exposed for exaggerating earnings or resources in their North American filings, and Carnes has played a part in exposing some of them.
He employs researchers to do due diligence on Chinese companies for his own investment purposes.
He and his team spent several years living in China, until one of his researchers – Kun Huang – was thrown in jail for two years after being convicted of defaming Silvercorp.
Huang is now suing Silvercorp for false imprisonment, defamation and damages. He alleges the company not only aided Chinese police in its investigation, but also paid their expenses – allegations that have not been proven in court.
Typically, Carnes makes long investments in Chinese companies he deems to be good bets. But when he finds one he considers dubious, he takes a short position in them, meaning he cashes in only if the company’s stock sinks.
And in some cases, he helps with that sinking by publishing detailed technical reports based on research done in China.
Carnes and other short-sellers – notably Muddy Waters Research – have exposed alleged fraud committed by several Chinese companies – Sino-Forest Corp. (TSX:TRE), for example, which was delisted from the Toronto Stock Exchange and forced into creditor protection.
Seven companies that Carnes has shorted and reported on have also been delisted, and fraud charges have been levied against a number of them, according to alfredlittle.com.
But Teresa Mitchell-Banks, director of enforcement for the BCSC, said an investigation into the allegations against Silvercorp found no evidence of wrongdoing.
“Just because a company is from China doesn’t mean it’s a fraud,” she said. “You can’t paint every company with the same brush.”
In his reports on Silvercorp, Carnes said he never alleged fraud – just questionable reporting.
Silvercorp has put up a vigorous fight, in both China and North America. As Silvercorp vice-president Lorne Waldman pointed out in an email to Business in Vancouver, it was Carnes, not Silvercorp, who became the target of a BCSC fraud investigation.
“There was an investigation which resulted in fraud charges against Mr. Carnes while Silvercorp has never had to restate any financial results or withdraw any public filing,” Waldman said.
Carnes alleged that, in its North American filings, Silvercorp overstated reserves, grades and production at its operations in China. Shareholders who won an out-of-court settlement against Silvercorp in the U.S. made similar claims.
While the BCSC panel found Carnes cherry-picked the opinions of geologists hired to analyze Silvercorp’s technical reports in China to come up with a more damning report, it concluded that he was expressing an opinion on a company he believed to be overvalued.
“It is not our role to sanction all persons who publish opinions about public companies,” the panel wrote.
But it wasn’t just how Carnes used information in his reports that the BCSC took issue with. It also objected to his use of a pseudonym – Alfred Little – and a “grossly inflated” biography “to lend credibility to his published reports.”
Carnes said there’s a good reason for the fake identity. In 2010, when he criticized China Natural Gas – which has since been delisted – even though the blog was published anonymously, Carnes said the company found out through his IP address where he was operating in China.
“Just like I feared, they sent someone to our office who threatened us.”
Carnes added that adopting the Alfred Little persona helped him cover his tracks.
Short-sellers sometimes work with each other to help bolster their cases against the companies they’re shorting.
Self-serving though short-selling may appear to be, it serves a purpose in the public markets, said Sprott US Holdings chairman Rick Rule.
“I think it’s part of a normal market. It’s part of price discovery. I think, in a sense, it’s economic freedom of speech.”
Short-sellers challenge the sometimes overly optimistic claims companies make and can assist in setting more realistic valuations, he said.•
