Now It's Silvercorp's Turn to Gets Scammed

Several years ago during a period when many small-cap Chinese stocks were routinely accused of being frauds, silver miner Silvercorp (NYSE: SVM  ) fought back hard against allegations that it, too, was manipulating results to scam investors.

Still facing potential class action lawsuits from the fallout over those charges, the last thing it needs is to do something that brings into question corporate governance practices. But it recently announced that rather than scamming investors, it was the one being scammed -- by its own contractors!

With four mines, Silvercorp is China's largest primary silver producer , and to maintain its position as a low-cost producer in an environment that has seen the precious metal fall sharply in value, it routinely reviews its operations to look for ways to squeeze additional savings out of them.

It was during one of these reviews that it discovered the scam being run by some of its contractors in the Ying mining district. The contractors had been paid on the basis of how much ore was mined and their trucks were weighed once at entry and once when exiting to determine the fees. What Silvercorp's investigation found was its contractors were loading up their trucks with waste rock from development tunnels in between the scales resulting in diluted ores and reduced head grades of silver. Needless to say, its operating costs rose, too.

In its first fiscal quarter for 2014 Silvercorp reported it had mined 29% more ore than it did a year ago, but only produced 17% more silver. Production costs for silver in the Ying district rose from $9.20 per ounce to $9.63 while head grades for silver fell from 227 to 200 grams per tonne.

It's not always scams that lead to higher costs. Hecla Mining (NYSE: HL  ) reported quarterly results last month that saw expenses rise due to its acquisition of Aurizon Mines leading the miner to report an adjusted loss of $10.2 million, or $0.03 per share. BHP Billiton (NYSE: BHP  ) produced 9% less silver last year than it did the year before, and Pan American Silver (NASDAQ: PAAS  ) produced 3% less as a result of production sequencing challenges at several mines. All were affected by lower silver prices.

Once Silvercorp found out about the scam, the miner immediately changed the formula for how it paid its contractors. Now it uses assayed grades to determine the amount of ore to waste mined during the month and also dilutes by 10% to 30% the ore produced to account for waste materials that may be too difficult to measure accurately. In that way, it calculates the amount of ore extracted by the contractors and how much to pay them. While the ore continues to be weighed at the gates of the tunnels, it's now only being used as a reference.

The result has been an immediate 35% improvement in silver head grades at Ying and 21% for lead. However, it's also led to a 45% decline in ore production and 25% less silver as some drillers and miners left because it created uncertainty and volatility around their fees. I guess when you can't game the system, it's better to go elsewhere.

When faced with adversity, Silvercorp has moved to be out in front of the problems. It was the miner that revealed that someone was blowing the whistle on its alleged financial shenanigans, and it proactively attacked the cabal of short sellers who were teaming up to knock the its stock down. While it eventually dropped the lawsuit against them (after having been dealt a blow by the courts, which dismissed the charges), it also hired two well-known consulting firms to prepare an NI 43-101 report to lend more credibility to its mineral assessments while also bringing accountants in from KMPG to go over its books.

That last may have been a bit self-serving, as it was given a clean bill of health, but it was Silvercorp that brought to the fore the problems with its contractors and immediately took measures to remediate them.

Its shares have been cut nearly in half over the past year, but that has more to do with the state of silver these days than with the miner, and because I'm very bullish about silver's long-term future, I think this scam by its contractors will lead to a stronger company that will profit when the gray metal rises once more.

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