Guanxi vs Analyst: Carlyle and the coming collapse in Asian Private Equity

I have a friend with a fair career as an analyst in Asian private equity funds.  He describes the central debate as being between the “Guanxi guy” and the “Analyst guy” (in his world they are mostly guys) and he says the “Guanxi guy” has won almost all of the battles.

“Guanxi” is one of those words proponents claim defies easy translation: something between connections and relationship.  Wikipedia defines it as a personal relationship between people in which one is able to prevail on another to get things done.  Whatever: Guanxi is often sold as the key to doing business in China.

At Private Equity (PE) firms the debate as to which deals to do and what price to pay has been between the Analyst guys and the Guanxi guys - and with the Guanxi guys winning almost every time.  Analysts - when they have reservations about deals - are seldom heeded.

Some analysts - not wishing to besmirch their reputation with bad deals done for the wrong reasons struck out and started their own small private equity funds.  When they find the deals they try to fund them and discover that the banks (or their Guanxi connections) want to take a piece of the equity.  I guess that is the price of doing business.  But even after paying up they find the banks want to charge them over-the-odds for funding.

So the deal goes to some Guanxi guy - and the banks queue up to do the funding at low spreads.  (Whatever you say Sir says the banker...)

And so - in the great Guanxi vs Analyst debate Guanxi repeatedly wins.

Guanxi is less important in the West - but connections remain important.  The definitive Western Guanxi firm is Carlyle.  Carlyle is a private equity firm known for employing senior political figures and using those connections to win deals - but also for their knowledge of how government functions.  The list of famous employees is large and include:

George H W Bush
George W Bush
James Baker (former Bush Secretary of State)
Mack McLarty (former White House Chief of Staff under Clinton)
John Major (former British Prime Minister)
Anand Panyarachun (former Thailand Prime Minister)
Fidel Ramos (former Phillipine President)
Arthur Levitt (former SEC chair)

I could go on - the list is extensive.

Carlyle is conspiracy theorist's dream because with all of those famous and well connected people the company understandably has important and profitable investments in the defence establishment.

But in Carlyle’s defence - many of these people not only bring connections but they bring knowledge and understanding of what is important to government and the defence establishment.  The first President Bush for instance was also the CIA director - he almost certainly knows what is important to the CIA and how to sell stuff to them - and he would know that without exploiting any connections.  These people are hired for the connections and for their knowledge.

Carlyle has taken this way of doing business to Asia and has hired many important and well connected people in Asia.  I listed a former Phillipine President and a former Thai Prime Minister.  There are many more of these people in China - notably the children of party officials.

Alas I think Carlyle’s business model in Asia is fundamentally flawed: we can see this through a purely hypothetical example.

Imagine if Chelsea Clinton went to work in business and to sell her connections.  (I know nothing about Chelsea Clinton other than she got married recently - so this example is purely hypothetical.)  And suppose that with considerable hard work at some Wall Street or Private Equity shop she wound up with $5 million.  (As I said I know nothing much about Chelsea.)  We would not be terribly surprised if Chelsea wound up with $5 million - we might think it unseemly - but it would also by Western standards not be terribly surprising.


However if Chelsea - through nothing other than her connections - were to wind up with (say) $500 million then that would be unseemly.  Journalists would be all over the story and the integrity and morality of the people involved would be questioned.  Indeed it would be so unseemly it would not happen.  

There is a line here - $5 million is sort-of-OK.  $500 million is clearly not.  I suspect the line is at high single-digit or low double digit millions.  Obviously the line is higher for a President than it is for a President’s daughter.  Whatever: the social sanction matters.*  The cynics would argue that there is a socially acceptable amount of looting.  I prefer to think that wages - particularly of people who sell their “Guanxi” are socially conditioned.

That social sanction is considerably different in Asia.  There are several “Princelings” in China (children of party officials) who have made hundreds of millions of dollars (or more).  Suharto in Indonesia complained that that which the high-and-mighty in Washington thought of as “corruption” he saw as “family values”.

And thus we see Carlyle’s problem in Asia.  In the United States the Guanxi guys will work for single-digit millions annually and think they are well paid.  That is all they are entitled to.  Such limitations on entitlement do not exist in Asia - and the Guanxi guys are likely to see Western funded private equity shops like Carlyle as piggy banks to loot.  Sometimes they will be looted by the Guanxi staff but more likely they will be looted by Guanxi connections of of the Private Equity shop's Guanxi staff.  And the looting will not be a million or two dollars here and there - it will be for every penny they can extract.  The losses could be enormous.

To this end I present to you China Forestry.  China Forestry was a billion USD Hong Kong listed Chinese company with many Private Equity funds having stakes.  The leading stakeholder is Carlyle (or more precisely funds belonging to Carlyle’s clients).  The stock has been suspended after admitting “accounting irregularities”.  But it is worse than that.

China Forestry had a business model which consisted of fast-growth forestry to extract greenhouse gas credits - a business model that barely made sense to some analyst guys that looked at it.  However it was a business model that made sense if the company had enough Guanxi - enough connections to extract a really bad (ie nonsensical) deal from the Chinese government.  And the holders of China Forestry to some degree believed just that.  They believed in the Chinese Guanxi.  And implicitly they believed the deals were being bought to them by the Guanxi of their staff.

Now China Forestry remains suspended.  No reasonable questions are being answered - so I am going to reveal to you the Analyst gossip: the bulk of the forests do not exist.  Sure they had some “front” - plantations they would take potential investors to.  But the vast bulk of the business was a fiction and “accounting irregularities” is code for “fiction”.

Oh - and Carlyle has dusted 105 million dollars.

If this is fraud then Carlyle has a little egg on their face.  After all - what is the point of having all those investment professionals if they get dusted by the simplest of frauds.  The whole point of private equity is that by pooling capital you can get insider positions and you can run the company for cash - for the benefit of your investors.  But if your “insider position” doesn’t even allow you to spot the business does not exist then your insider status is worthless.  You might as well close up and go home.  You have no right to be in business.

This blog has been detailing another stuff-up of Carlyle.  I am short China Agritech - a company listed on the NASDAQ with operations in China.  At least the operations are meant to be in China but after considerable looking (only part of which has been detailed on this blog) we cannot find any convincing evidence that the bulk of the operations exist.  In this case Carlyle is the biggest investor and has exercised its right to appoint a board member.  Again it looks like they have been dusted.

The analyst guys are cock-a-hoop.  They think that now the great Analyst-Guanxi debate will now - at least sometimes - be resolved in their favour.  I think that is optimistic - this sort of “network capitalism” is too entrenched for a few stuff ups to upset.  What is required to blow this apart is a collapse of the entire network.

Only after the collapse of  network capitalism will the system be cleaned up and capital be allocated on the basis of analysis rather than connections.  Whilst I am only nominally an Austrian economist - there is a long empirical history that this sort of stuff lasts until it doesn’t - until it has its “Minsky Moment” and only then is it replaced by something more sensible.**

So - on the basis that the system really is entirely stuffed up - and a blogger in Australia can find the empirical evidence for that stuff up I am predicting the collapse of the Asian Private Equity business.  And Carlyle - the most Guanxi of all firms - will be the centre of that collapse.



John


Note 1:  The other investment in Asia I am following which - at least on my analysis - barely exists - is China Media Express.  CCME has been the subject of a few blog posts - but the main argument for the veracity of the company is the investment by Starr Asia.  Starr is Hank Greenberg (ex AIG).  Hank has more Guanxi than any other Westerner in China.  He is an impressive man.  However I suspect he has been done by his Guanxi here too.


*Note 2:  Chelsea Clinton did work for Avenue Capital Group (a hedge fund and private equity group).  However this has been entirely without scandal.  In the West it usually is without scandal.

**Note 3: It is entirely possible that post-scandal the capital will be allocated according to the time-honored Asian tradition - stick the losses to the foreigners and the profits to the guys with Guanxi.  (See Asia Pulp and Paper or GITIC for examples.)

Family values in the emerging market ruling class

I have just finished reading James Wolfensohn's autobiography - a book that will inspire a few blog posts.

The new consensus is that emerging markets are lower risk than developed markets - they have more favorable demographics and more sound fiscal policies.

They also have more colorful politicians.

This - the best quote in Wolfensohn's book - should give believers in the new consensus pause:

In early 1997, I met with the Indonesian President Suharto in Jakarta.  The president asked me ... what I was doing raising the subject of corruption as an issue.  I told him we couldn't talk about development without addressing corruption.  He replied, "Well, you come out here from Washington with these high ideas to tell us about corruption.  But what you call "corruption" I call "family values".

John

China Agritech: more photos - more detail

In the last post I (erroneously) showed pictures of a gate of a plant supposedly leased to China Agritech. This was the photo as supplied to me.

The sequence was that the American lawyer in Shanghai who I hired to do this project had a (junior) colleague in Anhui for New Year. Her family came from Anhui.

She visited the site. She got several photos of the plant by poking in the Window but did not supply a photo of the gate. I have included one - it is a metal-working plant as advertised. Alas she supplied me the photo of the gate from the website of the metal working company - not a photo she took herself.

So my Shanghai lawyer went to Anhui (standing room only on the train!) and took the photos himself today. He was - when seen taking photos - escorted quickly off site. However he found the mysterious China Agritech office.

Here is the building on site in which the China Agritech office resides.

There are more modern factories on site - but this is the office building.

China Agritech has its office on the second floor on the right hand side of this building. The office was deserted - it was after all the New Year holiday. It is not large - but this office is the only evidence that China Agritech had any facilities that we found.

There was no fertilizer plant on this site - even though this was clearly the low-rise site where - according to the SEC filing - China Agritech leased its Anhui Plant.

Finally the road to the site was not a rutted road as described in the Lucas McGee report - indeed it was a large site with more than one gate. Here is one gate - my contact was sent off site before he photographed the gate as photographed in the last post.

We have now clearly found China Agritech facilities - but they are NOT the plants as described in China Agritech filings. They are however at the addresses given for those plants in the Agritech filings.



John

China Agritech: a follow up

THIS POST HAS IMPORTANT QUALIFICATIONS - SEE THE POST SCRIPT.  PLEASE READ THE QUALIFICATIONS AS AN IMPORTANT PART OF THIS POST.

China Agritech is a NASDAQ listed Chinese company that is – according to its SEC filings - in the business of manufacturing and distributing organic fertilizer.

The annual filing lists their capacity as follows:

... annual production capacity as of December 31, 2009 was approximately 13,000 metric tons of organic liquid compound fertilizers whereas ... annual production capacity for granular fertilizers as of December 31, 2009 was approximately 200,000 metric tons, consisting of 100,000 metric tons in Anhui, 50,000 metric tons in Harbin, and 50,000 tons in our newly completed plant in Xinjiang.

In my last blog post I noted that:

(a) A hitherto unknown shortseller (Lucas McGee Research) had released a report that suggested that key plants either did not exist or were entirely incapable of producing at the levels indicated in the annual filings.  Lucas McGee research - as company promoters have been keen to point out - operates out of a virtual office and have a very limited history.

(b). The biggest shareholder is the world's most powerful private equity firm (Carlyle). I did not note – but Carlyle has filed a prospectus to register (and hence sell) their stock.

(c). The company has issued a denial of the shortseller report and claimed that all their plants and distribution centers are as listed in the annual filing.

I have a short position in the stock. I am keen to verify or reject the claims in the short seller report. (If I rejected the claims I would switch and go very long the stock.  The stock is on-face cheap - and it is liquid enough that I could change my position in minutes.)

I wrote to Carlyle – and to Anne Zheng (a staff member of Carlyle and Carlyle's representative on the board of CAGC) – to see if Carlyle would confirm or deny the shortseller report. Alas I got no answer.

That makes research a little harder.  This post is a summary of my research efforts.

The research efforts of course wound up against the normal epistemological problems of proving the existence or non-existence of things.  In this case, if you find the plants and you count the trucks entering and leaving the plants with amounts of fertilizer on them consistent with the company filings you have proved the existence of the company and disproved the short case.

If however you do not find the plants you have not proved the short case - the plants could be somewhere else - or closed for a reason - or you could have the address wrong or any other similar snafu.  It is hard - nay impossible - to prove a negative.

So - if the short case is right - the best I could expect to do is find data consistent with the short case.  I did not expect to be able to prove the fraud.

The key shortseller allegations

Here are the key shortseller allegations as stated by Lucas McGee (the shortseller):

Sinochem (a claimed large customer) has told us that it does not sell any Agritech products 

Government officials in China told us that Agritech does not have a license to manufacture granular fertilizers, which the company claims are its largest product line. 

After visiting Agritech’s reported manufacturing facilities in Beijing, Anhui, Xinjiang, and Harbin, we found virtually no manufacturing underway. The single exception was the facility in Pinggu County on the outskirts of Beijing, where the plant was not in operation on the Friday when we (Lucas McGee) visited but local people told us that it has sporadically produced some liquid fertilizer over the last year. 

Plants in Bengbu, Anhui (supposedly the largest), Harbin, and Xinjiang were completely shuttered.

Obviously these are allegations that go right to the heart of the company.  Instead Lucas McGee suggests that money is being stripped out of the company by inflated rents to related parties.  

If the Lucas McGee allegations are correct then the company will probably trade well under a dollar at some future date.  

The company has categorically denied these allegations. Firstly it has pointed to a contract with Sinochem previously filed with the SEC (I will get to that contract later).  Further the company has photographs of bags of granular fertilizer and some liquid fertilizer. And it has said that “the company and its subsidiaries are operating normally.”

As stated – after repeated requests – Anne Zheng (the Carlyle executive on the China Agritech board) did not confirm or otherwise vouch for the company's position.

Doing the work myself

Given that I could not rely on Carlyle, I employed a lawyer in China to visit the plant and see what they could find. This was made somewhat more difficult than usual because of Chinese New Year celebrations. You would not expect the plant to be operational during the holiday – and hence you could not check the volume of the plant by, say, counting trucks visiting.

The Anhui plant

I chose the China Agritech plant in Anhui because (a) it is listed as the largest plant run by the company – doing 100 thousand tonnes per year of fertilizer, (b) the Lucas McGee report suggested that it was shuttered and (c) it was fairly close to Shanghai and hence possible to visit.

Here is what the shortseller report said about the plant.

In Anhui, which Agritech calls its principal production facility, $400,000 worth of plant and equipment would seem slim for 100,000 tons of production capacity. We visited and found a small plant on a rutted road outside Bengbu, completely deserted.

Lucas McGee give a photograph.

This (surprisingly) was not the plant we found.  We found the plant we photographed  from following SEC filings.  

The annual filing gives the addresses of the plants as follows:

The Anhui plant is giving as  Changzheng East Rd, Gaoxin District, Bangfu City. The plant is (according to this part of the annual filing) large (3,400 square meters) and the rent is USD32,488 per month. (You can calculate the rent per square foot and my knowledgeable China contact suggests that this is high for low end industrial rent in China.)

Changzheng (the street name) translates as “Long March”.

There is another SEC filing (a quarterly) which gives a lease agreement for a plant in Bangfu City.

The address is consistent (1188 Changzheng Road Gaoxin District, Bengbu.)  I am presuming that these are the same plant - as there is only one plant listed as rented in Anhui in the property section of the annual report.  

We have however had problems with this in translation.  Some translations have it as "Long Road" Gaoxin District – rather than “Changzheng Road” or “Long March Road”. You can see that translation in using a Google translation of this 2007 job advert.

The lease gives the space as 1338 meters squared – considerably smaller than the 3400 meters square in the annual report. The rent is also considerably less than the annual report (commensurate with size) but the rent per square foot was higher - and high according to my (knowledgeable) contact.

Anyway my contact visited this site – and it is clearly an industrial site – but there is no large fertiliser plant on the site. The ground floor is held by the Bengbu Yi Machinery Factory and the Bengbu Equipment Factory. These are metalworking shops – and their sign is on the front door.

Here is the photograph.

THERE IS AN IMPORTANT CAVEAT REGARDING THIS PHOTO AT THE END...

There were not a large number of people on site. That was not surprising as it was Chinese New Year. There was however a security guard – and my contact talked to the security guard. He had never heard of China Agritech – or even Anhui Agritech. However it turned out that they did have premises on the second floor of the building – though nothing as large as the amounts indicated in either the lease or the annual.

There were no smells associated with organic fertiliser. Organic fertiliser as most people would know smells somewhat.

Moreover – and this is an obvious point – a fertilizer plant that processes 100 thousand tonnes of fertilizer per year is vanishingly unlikely to be on the second floor. 100 thousand tonnes of fertilizer is 2.5 million 40kg bags of fertilizer.  Moving this requires trucks and loading docks and the like.

The Security Guard said that the Bengbu Equipment Factory moved here approximately 3 months ago. He was not aware of either China Agritech or Anhui Agritech having any other premises. A cursory online check with the Administration of Industry and Commerce database showed Anhui Agritech only at this address. My lawyer-contact in Shanghai noted that it would be breaking the law to be operating from a second address without including that address in the database.

This all sounds consistent with the Lucas McGee report, however I note a glaring inconsistency.  This appears to be a different premise to the one photographed by the shortseller report. 


The shortseller premises are a small plant on a rutted road whereas my contact suggested that this was a more urban plant.  It would be sensible to have a fertiliser plant at an address closer to the outskirts of town, after all fertiliser is a bulk commodity and organic fertiliser smells. Moreover it is used outside towns – so premises on the outskirts of town make more sense than this site.

It is possible then that the premises are different from the ones mentioned in the annual report. However our contact visited the premises in the annual report and they did not find a fertiliser plant capable of producing 100 thousand tonnes per annum.

Moreover - considerable digging on the internet has meant that we have found an advert for a plant lease for 1338 square meters at the same address as the Anhui Agritech lease.  The same address and the same plant size to the square meter suggests that the plant was released.  This is consistent with Bengbu Equipment Factory moving into premises previously occupied by China Agritech - however we have no information that the premises were ever occupied by China Agritech.  The security guard did not know China Agritech...  

The Sinochem contract

China Agritech has claimed Sinochem as a major customer. Lucas McGee says that they talked to Sinochem and Sinochem denied being a customer. The company in their defence has pointed to an SEC filing that details a contract with Sinochem. Here is that filing.

The filing is interesting. It is for liquid fertiliser and in surprisingly small quantity. The contract is for liquid fertiliser in tiny bottles. I quote:

Name		Package Size			Number				Volume (L)				Unit Price (Yuan /L)				Purchase Amount (Yuan)
organic condensed liquid compound fertilizer (Broad Spectrum Type)		15ml *300 packages/piece				5,000				22,500				60				1,350,000
organic condensed liquid compound fertilizer (Broad Spectrum Type)		180ml *50 bottle/piece				100,000				900,000				55				49,500,000
organic condensed liquid compound fertilizer (Anti-disease Type)		20 mil * 300 bag/piece				25,000				150,000				66				9,900,000
Total (RMB)		60,750,000

Note: the prices above include packaging price, Party B shall pay transportation fee.

These are tiny bottles – sometimes only 15ml and always less than one fifth of a litre. The contracts include packaging.  A 15ml packet is probably enough for one to five shrubs - not a commercial farm.  The instructions (in Chinese on China Agritech's website) suggests that the liquid be diluted 1000 to 1 before watering plants.  A 15ml packet would do a watering can.  

The total contract is for just over a million litres – or just over a thousand tonnes. This is tiny for a company that produces (or claims to produce) over 200 thousand tonnes per year of fertilizer - and indeed the main product appears to be packing and handling.  

This Sinochem contract is probably real (contrary to the suggestions of the shortseller).  But the contract is tiny and unlikely to be financially relevant. 

Moreover, the contract is not agricultural supply (which is done in bulk) rather a packaging contract for the sort of product someone use to fertilize their home flower patch. I might buy a small bottle of fertilizer for my (postage stamp size) backyard.

Moreover this contract is consistent with what the shortseller said about the company – they said that the company produced small quantities of liquid fertiliser at Pinggu County on the outskirts of Beijing. Indeed the contract was signed in Beijing. 


The company's photographic evidence 

The company has presented several photos to prove the plants are there.  The photos show plants but without loading docks or the like.  They also show liquid fertilizer packing.  They show a total of five 40kg bags of mixed organic/NPK fertilizer.

They are however not supportive of the proposition that this company produces 200 thousand tonnes (5 million 40kg bags) of dry fertilizer annually.

Several of the photos are of packaging and distributing very small quantities of liquid fertilizer.  Here is one example.

Summary

I sent a researcher to the company's stated main premise to see if I could find a plant capable of producing 100 thousand tonnes per annum of bulk fertiliser. We did not find that plant.

The company has protested there is one there. The premises appear different from the one the shortseller visited – but I found stuff consistent with what the Lucas McGee report and inconsistent with what the company says.

The Lucas McGee report said that no contract with Sinochem existed. I am satisfied that Lucas McGee is wrong on that point. A small contract for liquid fertiliser for retail use exists – and the company is capable of bottling such a product. However it is entirely possible that no bulk-dry-product contract with Sinochem exists.  The contract in the SEC filings does not support the proposition that Sinochem is a meaningful customer relative to China Agritech’s claimed sales.

China Agritech has produced photos to support the existence of their main business. These photos are alas entirely consistent with the shortseller claims - in that they do not support the proposition that there is a business capable of distributing 5 million bags of fertilizer.  Moreover none of the photos is labelled or geo-tagged in any way that helps verify the existence of the company.

I am staying short.




John

Some people have noticed - that unbeknown to me - my Chinese contact took the photo of the gate from a website.

I have attached the document the Chinese contact sent me.  Here it is

http://www.calameo.com/books/0005679007df8943103d9

I agree the document is IDENTICAL to the one taken from the website.  I instructed him clearly to TAKE photos -

He just says "Here is a picture of the gate".  He never told me he TOOK the picture of the gate.  Though my instructions to him were clearly TAKE PHOTOS.

I will follow up with photos HE TOOK.

----------------

The current state of play is this:  The lawyer in the states had a colleague swing by the factory on her way home.  She was visiting her family in Anhui for Chinese New Year and SHE provided photos including photos of the metalworking.  She also provided the photo of the factory gate - a photo that perplexed me because it was NOT a photo that matched the photos in the Lucas McGee report.

My lawyer in Shanghai cannot explain why the photo came from the website and was not taken on her phone.

He is trying to follow this up.  I will have a further follow up details when available.

Flagrant breach of copyright by TeacherSoft

There is a really fine company out there – we will call it TeacherSoft.  TeacherSoft wants to build the best possible education platform and market it globally.

To do this it inserts in 100 thousand classrooms a classroom recorder.  The recorder records everything the teacher does.  TeacherSoft of course has the consent of 100 thousand teachers to insert the recording equipment.

The recording equipment is very powerful.  Not only does it record what the teacher says – but using speech recognition software it converts all of that material to text and it uses that text in its own business.  

TeacherSoft also – in building the best possible education platform – uses many other signals.  For instance it uses exam results sometimes adjusted for the socio-economic status of the kids.  

The teachers are of course informed about TeacherSoft – and they endorse its programs.  TeacherSoft of course shares some of the benefits of that program with the teachers.  The teachers in the process pass the information freely knowing it will be shared.  That is of course the deal.

Now one particularly fine teacher gets a little stroppy when her teaching technique is featured heavily in TeacherSoft's lucrative platform.  She thinks she should be entitled to share in the wealth.  Alas she does not have a leg to stand on – she consented to the use of any copyrights she owned.

Joe the novelist

Joe is a children's novelist.  The novels are not long – a couple of thousand words at most.  They are a length that a teacher can read them to a kid on a hot Friday afternoon – when the kids are a little rowdy and are not really up to arithmetic lessons. 

Joe's novel is of course incorporated into TeacherSoft's database.  A teacher read it aloud – and through sophisticated speech recognition software the whole novel got included in TeacherSoft's teaching kit.

It's not an exact copy of Joe's novel though.  The teacher read it but mispronounced a few words and took breaths at the wrong places and hence the punctuation is slightly incorrect.  Also – because TeacherSoft's systems are not perfect the spelling is incorrect in a few places.

But it is a copy of at least a part of Joe's novel.

Joe objects

Joe doesn't like TeacherSoft making profits from Joe's novel.  Joe owns the copyright – and he politely asks that whenever TeacherSoft notices Joe's novel in their database they exclude it.

TeacherSoft does not accept Joe's claim.  They say they did not copy Joe's novel.  They just watched the “teacherstream”.  They don't see one part of the teacherstream – the part based on novels – should be prioritized or not prioritized over any other part of the teacherstream.  The novel is just a small part of a teacherstream.

Joe is upset.  His novel has been – in part – copied.  He seems to have no redress other than issuing a cease-and-desist.

Is it copyright abuse?  

I think this is obviously copyright abuse.  The copy of Joe's novel – or even parts of it (as long as those parts do not fit into a fair use exemption in the copyright law) are breaches of copyright.

TeacherSoft argues that it has not breached Joe's copyright.  It has permission from classroom teachers to use their teacherstream.  They just got the material from the teacherstream and they have permission to use that.

So what.  They don't have Joe's permission.  And Joe has sent a cease-and-desist letter.

And if TeacherSoft were to continue to ignore the cease-and-desist then TeacherSoft would be liable for breach of copyright.  If this were a case of a lot of little Joe's and one big nasty corporation I would even go as far as to suggest that a visit from criminal regulators would be appropriate.  Of course it would never get to that – but if done on a grand scale and with flagrant disregard for copyright it would be criminal.  

The Microsoft analogy

This is – of course – a direct analogy to Google's claim that Microsoft is breaching their copyright.  This is a claim that almost all my readers have disagreed with – but which I think is a lay-down.  

Ed Harrison (from the wonderful Credit Writedowns) refers me to an article by Danny Sullivan.  Sullivan writes more about Search than anyone else on the web – and knows his way around.  His argument is this:

The Search Signal Doesn’t Overrule Other Signals

Let’s step back. There’s no “Google signal” but rather a “search signal” that Google activity is mixed into. That search signal is further mixed in with other ranking signals, a dilution that is crucial to why Bing so strongly rejects Google’s claim that it is copying its results.

Most of Bing’s searches — popular so-called “head” searches — are not heavily influenced by the search signal, Bing says. There are many other signals that come into play.

“Movies” would be an example of a head search. That’s a search that’s done by thousands of people each day, and a search topic with lots of “signal” to measure. Bing can determine if pages are relevant to that term based on the words that appear on the page itself; how many people link to some of these pages with the word “movies” in the link; how authoritative those links seem to be, and more.

Bing can also examine how people click on its own results that it lists in response to that search. If a page doesn’t get as many clicks as would be expected, it might get dropped further down on the list. Pages that get more clicks than expected can be a sign that users find them more relevant than Bing’s ranking algorithm did originally, and so that can be used to boost them.

In addition to these and other signals, Bing can also turn to the surfstream to perhaps give a boost to pages that it sees are well visited by Internet Explorer users.
“Bombilate” would be an example of a “tail” search, a search that’s rarely done, and on an unusual topic. Here, there are fewer signals to assess. Only a few pages might be found. These pages might have few links pointing at them. Since the term isn’t searched for often, measuring clicks on Bing’s own results might not help much much. This is a case where the surfstream — as well as the search signal within it — might count more.

Microsoft is arguing that there is no “google search signal” there is just clickstream.  They don't distinguish Google clickstream from any other clickstream.  That they wind up copying part of Google's database (and a small part at that) is an accident of clickstream – it is not copying.

Ok – and TeacherSoft argues that they are not copying novels – they are just using teacherstream.

Microsoft argues it has permission to copy a “clickstream”.  TeacherSoft argues it has permission to copy a clickstream.  But they do not have permission from Google or Joe respectively – and it is Google or Joe's copyright they are breaching.

Microsoft's argument is ultimately very weak.  Google has copyrighted search results.  They wind up in Bing's search engine.  Joe has a copyrighted novel.  It winds up in TeacherSoft's education material. Both Google and Joe have a valid claim for breach of copyright.  It does not matter how technologically sophisticated the method of copying.  The novel and Google's data are copyright and they are copied.

Microsoft is also a huge hypocrite here – it regularly cooperates in criminal prosecution of people who breach copyright.  Yet Microsoft flagrantly breaches copyright – and ignores a cease-and-desist.  

I opposed the original anti-trust action against Microsoft.  But this time – and much to the annoyance of most my readers – I really do think the Justice Department should become involved.   

I know my readers disagree with me.  That is kind of nice.  Part of the joy of this blog is to find smart people who disagree with me - and I have found them here.  But I still don't think I am wrong.

John

The original Google release is here.  And Microsoft's reply is here.