A damning short-seller's report accusing Sino-Forest Corp of theft and fraud put the skids under the Canadian-listed company on Friday, even as it denied there was a problem.

Sino-Forest, which operates forest plantations in China, told investors to exercise extreme caution in assessing the report, issued by research firm Muddy Waters.

Muddy Waters has a short position in the company's shares and therefore stands to realize significant gains from a share price decline that it precipitated, Sino-Forest said in a statement on Friday. Its shares fell 24 percent on Thursday.

Stock in Sino-Forest, whose top shareholder at the end of April was billionaire hedge-fund manager John Paulson, fell a further 65 percent on Friday, hitting a new low of C$4.81 before closing at C$5.23.

A record 42 million shares changed hands, making the company Toronto's most active stock by far.

CHARGES OF FRAUD, THEFT AND PONZI SCHEME

In a detailed, 37-page report, Muddy Waters said its researchers found that Sino-Forest had exaggerated its assets and falsified its investments.

Like Madoff, (Sino-Forest) is one of the rare frauds that is committed by an established institution, it said, referring to convicted fraudster Bernie Madoff. Its capital raising is a multibillion dollar Ponzi scheme, and accompanied by substantial theft.

Muddy Waters holds short positions on companies it reports on, and makes money when shares fall. It first won attention with a scathing report on Orient Paper Inc in 2010.

Sino-Forest, which says it employed 3,900 people and managed 790,000 hectares of plantation trees in China at the end of last year, has reported steady earnings growth since its stock was first listed in Toronto in 1995.

But it has also had its share of controversy. It restated earnings in 2004, the same year that it proposed an executive compensation plan that investors saw as overly generous.

The company actively buys and sells forests, according to a report from Poyry's. The industry consultant said the company had a dynamic forestry estate.

Unlike most forest owners and managers, Sino-Forest actively trades in forests. Each year the company both sells and buys forests, and accordingly the composition of the forest estate changes much more than for a business that is simply managing and harvesting a more static resource, Poyry's wrote in its 2010 annual report on the company's assets.

Thomson Reuters Starmine shows 10 analysts follow the company, with four listing Sino-Forest as strong buy, five as buy and one as hold.

Dundee Capital Markets analyst Richard Kelertas put Sino-Forest under review pending more information, but said he did not believe the Muddy Water charges.

To the best of our knowledge we believe that the allegations cited in the short-seller's 'research report' are false and without merit, he said, noting his conclusions were based on several years of conversations with management.

BMO Capital Markets cut its rating on Sino-Forest to market perform from outperform on Friday, and put its price target on the shares under review, pending a better understanding of the company's timber holding.

PROBING THE ALLEGATIONS

Sino-Forest said its board had appointed a committee of three of its independent directors to investigate the allegations and complained the Muddy Waters report had a substantial impact on its reputation and securities prices.

Sino-Forest wish to state clearly that there is no material change in its business or inaccuracy contained in its corporate reports and filings that needs to be brought to the attention of the market, the company said.

Paulson owned 14.13 percent of the shares as of the end of April 29, according to Thomson Reuters data. An investor familiar with the situation said Paulson & Co had informed investors that Paulson is looking at the situation closely.

Sino-Forest shares represent about 2 percent of his Advantage Strategy and are not owned in any other Paulson strategies. A Paulson spokesman declined to comment.

The Ontario Securities Commission declined to comment on the allegations about Sino-Forest, which has an office in Mississauga, Ontario, outside Toronto.

BOND SELLOFF

The Muddy Waters report also prompted a sell-off in Sino-Forest bonds and dragged down the China high-yield offshore sector.

Thomson Reuters data shows Sino-Forest has some $2.3 billion in debt financing outstanding, with credit ratings in the low grade, speculative range or junk status.

Its longest dated issue, maturing in October 2017, is currently yielding almost 17 percent, Thomson Reuters data shows.

Credit default swaps, which protect fixed income investors against default or restructuring, are trading with an immediate upfront cost to investors of $493,000 plus an additional $500,000 annually for the five-year life of the contract, according to data provider MarkIt.

Muddy Waters has also published damning notes on RINO International Corp and China MediaExpress Holdings , both of which have been delisted from the Nasdaq.

Following the report, RINO said its auditors had found accounting flaws. The chief financial officer at China MediaExpress later resigned, along with its auditors.

But some companies are fighting back.

Drew Bernstein, the chairman of Orient Paper's audit committee, said the Muddy Waters report on Orient was filled with untrue allegations. He said Orient Paper was perhaps the most vetted Chinese company following the report.

Its shares still trade on NYSE Amex.

(Additional reporting by Jennifer Ablan, Daniel Bases and Julie Gordon; writing by Janet Guttsman; editing by Frank McGurty)

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