Among the most promising-looking nuggets was China Medical. After all, General Electric had owned 20 percent of the firm when UBS took it public on Nasdaq in 2005. In August 2011, O’Leary wrote investors that China Medical stood apart from “Chinese frauds.” It was blessed with a first-tier auditor, PwC, and not sullied by insider selling. Within months, however, it became clear China Medical had its own problems. That December it defaulted on a bond-interest payment. Also in December, Glaucus Research Group, a California-based short seller, issued a report saying it believed the company had “defrauded investors,” in part by using sham acquisitions to “embezzle” tens of millions of dollars.
Deutsch and O’Leary say they took a hard look at the Glaucus report as well as a point-by-point response from China Medical’s management. (Glaucus says it stands by its research.) The two men remained confident the stock would ultimately be proven worth $30 per share, roughly 10 times its recent trading range. Its business apparently remained robust, and the $200 million in cash on its balance sheet was double its market value. Others saw value, too. In January 2012, Barclays recommended that investors “overweight” the stock. It described China Medical as “one of our top picks” and “a premium domestic player in the protected China medical diagnostics space, with a 70 percent potential upside.”
Deutsch decided to continue accumulating shares. In 2010 two Chinese health-care companies, BMP Sunstone and Tongjitang Chinese Medicines, had gone private at significant premiums. If Deutsch was right that China Medical shares had a fair market value of $30, the whole company could bring in close to $1 billion in an outright sale.
Not everybody agreed. John Hempton, an Australian short seller, says he cautioned the Deutsches in a letter back in September 2011 that AER might be leading them astray, only to hear from a lawyer. “I got back, via overnight international courier at a cost of about $300, a letter threatening to sue me” if he contacted the Deutsches again, Hempton says.
Then, in February 2012, Nasdaq stopped trading China Medical, which moved to OTC Link ATS. OTC Link doesn’t have listing requirements, and, as opposed to trading listed stocks, investors often must pay for OTC shares in cash—and in full. At the time China Medical started trading on OTC Link, Bill and Peter Deutsch owned 4.4 million shares, representing a 13 percent stake in the company.
Fidelity soon identified Deutsch as a promising supplier of shares for its fully paid lending business. On March 5, five days after China Medical moved to OTC, Amanda Topping of FFOS e-mailed O’Leary with an offer: “Fully Paid Lending Opportunity—CMEDY,” the subject line said, referencing China Medical’s ticker. Topping inquired if Peter Deutsch would be interested in letting Fidelity loan out his shares.
Securities lending is a $22 billion global business, according to Finadium, a consultancy. It entails brokerages borrowing securities from clients’ accounts and lending them out, for a fee, to short sellers. At least some of Deutsch’s China Medical shares qualified as “fully paid.”
Topping’s e-mail said Fidelity was willing to pay the Deutsches the equivalent of more than 7 percent annually to borrow shares. O’Leary rang Deutsch, who said he didn’t like the idea of arming short sellers. “I asked David, ‘Why would it be in my interest to lend out the stock?’ ” Deutsch recalls. “He said, ‘It wouldn’t be.’ ” An hour after receiving Topping’s e-mail, O’Leary replied, according to an e-mail entered in court: “Client is not interested in lending stock. Thx.”
What Deutsch was interested in was finding a buyer to take China Medical private. By June 12, 2012, he and his father, Bill, now 79, had increased their holdings to 11.9 million shares, or 37 percent of the company. That day, AER made a filing on their behalf that the U.S. Securities and Exchange Commission periodically requires of owners of 5 percent or more of a stock. It served notice that the Deutsches “may suggest or take a position with respect to potential changes in the operations or strategy of the Issuer, such as disposing of one or more businesses or assets.” (The timing of when the Deutsches took their activist position was amended in a later filing.)
As Carol O’Leary was preparing the filing, she says, she was surprised to discover that short sellers had managed to borrow 5 million shares of China Medical. The brokerages had to be getting them from somewhere, and she suspected they’d come from the Deutsches. But AER had already told Fidelity the Deutsches weren’t interested in lending their shares. “Had Fidelity gone ahead anyway?” O’Leary wondered. She says she e-mailed Mark Driscoll, AER’s rep at Fidelity Institutional Wealth Services, on June 12, the same day AER made the SEC filing: “I would like to know how much of our CMEDY stock has been lent out to short sellers.” Driscoll—usually quick to respond, she says—replied several hours later that he wasn’t at liberty to discuss China Medical.