Sino-Forest sues Muddy Waters for defamation

NEW YORK (CNNMoney) -- Chinese timber firm Sino-Forest filed a $4 billion defamation lawsuit against Muddy Waters, the research and investment firm that sent its stock into free fall last year after releasing a bombshell report accusing it of fraud.

At the same time, Sino-Forest also announced that it had filed for bankruptcy protection, saying in a statement Friday that it needed time to "normalize operations" following the allegations made in the Muddy Waters report.

"[T]he report was not designed to inform the investing public, but rather, to scare them into believing that Sino-Forest was a criminal and fraudulent enterprise," said Sino-Forest in the suit, which was filed in Canada's Ontario Superior Court. It accuses Muddy Waters of misrepresenting facts to benefit its short position in Sino-Forest shares.

Muddy Waters founder Carson Block told CNNMoney's Hibah Yousuf Monday that the lawsuit is "entirely without merit."

"There's a large amount of irony in that the day that they file for bankruptcy is also the day they sue us for defamation," Block said, adding that Muddy Waters is also considering a counter-suit.

Muddy Waters is part of a small group of firms that accumulate short positions in Chinese companies before publicly releasing reports detailing fraud allegations. A short position is essentially a bet that a stock will decline.

Following the publication of Muddy Waters' 23-page report last June, shares of Toronto-listed Sino-Forest lost more than two-thirds of their value before being suspended.

The company has since faced investigations by financial regulators in Canada and Hong Kong and by the Royal Canadian Mounted Police.

Sino-Forest's fall from grace

Muddy Waters described Sino-Forest last year as "a multi-billion dollar Ponzi scheme ... accompanied by substantial theft." Among other things, Muddy Waters accused the company of faulty accounting and overstating the value of its timber holdings.

Sino-Forest is seeking $4 billion in damages from Block, Muddy Waters and 100 other firms it claims traded on the report after receiving advance notice of it.

Sino-Forest went public in Canada via a "reverse merger," a quick and popular way for Chinese companies to trade publicly on U.S. and other international exchanges.

In a reverse merger, a privately held Chinese company typically merges with a publicly traded U.S. company, but gains the voting and operational control. With this move, Chinese companies have largely been able to avoid some of the regulatory hurdles that come with a traditional initial public offering.

Reverse-merger companies have come under increased scrutiny in recent years, with a number accused of fraud by short-sellers like Muddy Waters.

-- CNNMoney reporter Hibah Yousuf contributed