Perhaps the stock ticker should have given the game away. TRE, better known as Sino-Forest, a Canadian-listed Chinese lumber company, is one “E” short of a full “TREE”. Muddy Waters, the research firm whose “strong sell” note precipitated a collapse of Sino-Forest’s shares, alleges it falls considerably shorter than that. It has accused the company of “stratospheric fraud”, saying that it overstated its forestry holdings in Yunnan province by $900m and sent revenues through a maze of intermediaries designed to fool auditors.Sino-Forest, which listed on the Toronto stock exchange in 1994 through a reverse takeover, denies these claims. Executives launched an internal inquiry, still lumbering on – every pun intended – in which it sought to prove that its accounts provided a fair reflection of its forestry assets and earnings.
While Sino-Forest was busy counting trees, the Ontario Securities Commission acted. Last Friday, it halted trading of the shares, saying the company appeared to have exaggerated its timber holdings and to have engaged in acts that “perpetuate a fraud”. On Sunday, Sino-Forest said Allen Chan, its chairman and chief executive, had quit. Three other executives have been placed on administrative leave.
The fraud, if that’s what it turns out to be, fooled some of the world’s most savvy investors. John Paulson, the man who made $20bn by twigging that mortgage-backed securities were not, after all, as safe as houses, sold out Paulson & Co’s entire stake in Sino-Forest, losing $500m. In the past eight months, more than two dozen listed Chinese companies have shown accounting discrepancies or seen their auditors resign. Most of those companies are small and, like Sino-Forest, slipped onto foreign exchanges via a reverse takeover, which allowed them to bypass the scrutiny associated with an initial public offering.
Not all of the companies that have come under scrutiny got listings through the back door. This week, Longtop Financial, a China-based software provider that raised $210m through a New York IPO, said it may face civil action from the US Securities and Exchange Commission for failing to provide current financial statements. In May, Deloitte Touche Tohmatsu, Longtop’s auditor, resigned after it alleged that some information in the company’s accounts had been falsified.
Even in the most rigorous of environments, it is hard to verify the true worth of a company’s assets. In 2004, Royal Dutch Shell admitted to overstating its oil and gas reserves by 20 per cent. But China clearly is not yet the most rigorous of environments. For investors, especially ones trying to work out the worth of small companies whose activities take place several thousand miles away, China is more like the Wild West.
Muddy Waters says that even the Big Four auditors with offices in the mainland “have a number of issues detecting fraud”. Investors in Sino-Forest were placing their trust, among other things, in accounts being audited in Canada by Ernst & Young. The forests of Yunnan are an awful long way from Ontario. Grey rules on land ownership, as China makes the transition from a collectivised to a vigorously capitalistic economy, make such judgments harder still.
Even investors as experienced as Anthony Bolton, the star stock picker at Fidelity International who moved to Hong Kong in 2009 to take a better look at Chinese growth stocks, admitted to under-estimating the importance of due diligence in China. Mr Bolton’s China fund suffered losses in two small US-listed Chinese companies accused of fraud.

Apple, the US technology company, is the latest to stand accused of failing to conduct adequate due diligence – in its case in the selection of suppliers. A report released on Wednesday by Chinese non-governmental organisations alleged that several of Apple’s suppliers had a public record of environmental violations.

It should come as little surprise that it is easy to lose one’s shirt in China. Bookshops are full of volumes with titles such as Tim Clissold’s Mr China and Paul Midler’s Poorly Made in China that bear witness to the countless scams and frauds to which investors are vulnerable. The country is, after all, still in a stage of ultra-raw capitalism when fortunes are to be made by the brave, the crafty and the unscrupulous.
To state the obvious, shoddy business practices and outright fraud are hardly limited to China. Bernie Madoff’s Ponzi scheme was made in America and conducted under the noses of regulators who were supposed to be the world’s most sophisticated. Several biotechnology companies in the US and the UK have been found to have faked laboratory and clinical tests in order to bolster their value. Enron was an accounting fraud on a gigantic scale.
But China clearly does have a problem. Carson Block, the analyst at Muddy Waters who wrote the Sino-Forest report, says fraud is systemic. During a stint working in Shanghai, he saw countless entrepreneurs fall foul of cut-throat or dishonest business practices. Investors in China, he concluded, were being too naïve. His advice: buyer beware