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Activist short sellers: Heroes or villains?

Charles Zuo Qizhen

On January 24 2023, Hindenburg Research issued a report that wiped out more than $110 billion in market capitalisation from Indian multinational conglomerate Adani Group.(1) Titled “Adani Group: How the world’s 3rd richest man is pulling the largest con in corporate history,” the 100-page report accused Adani of engaging in stock manipulation and accounting fraud over the course of decades.(2) 

 

Who is Hindenburg Research?

Incorporated in 2018 by Nathan Anderson and named after the German passenger airship that burned down in 1937, Hindenburg Research aims to bring down disastrous companies that are bound to “blow up”. Hindenburg belongs to a group of organisations known as activist short sellers, who are characterised by their adoption of creative pseudonyms with connotations of bearish market sentiment and vigilantism (examples include “The Friendly Bear”, “Fuzzy Panda Research'', “Gotham City Research”).

 

What is short selling and who are activist short sellers?

In the stock market, an investor can take two types of market positions. Investors taking a ‘long’ position buy shares at a certain price and hope to profit from selling them later at a higher one. In contrast, a ‘short’ position bets that a stock price will fall. Short sellers borrow shares from other investors to sell, then buy these shares back at a lower price to pocket the difference. 

 

While traditional short selling is mostly done by hedge funds and institutional investors to protect their investments against falling stock prices, activist short sellers refer to market vigilantes who actively seek to expose companies with fraudulent business practices. Activist short sellers operate by first researching target companies that they suspect have questionable business or accounting practices. After taking short positions in these companies, activists then launch short selling campaigns by releasing public reports, often with sensationalist headlines, accusing them of various wrongdoing, with the aim of driving the companies’ stock price down. What distinguishes activist short sellers from non-activists is the former’s aggressive intention to publicly reveal negative company information. â€‹â€‹â€‹â€‹

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Although this practice is nothing new, the number of activist short campaigns have risen significantly from the 2010s as activists take to social media to disseminate their theories and analyses. According to data from Breakout Point, 2023 saw a total of 129 activist short calls, up from 113 calls in 2022.(3)

 

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Controversies with short selling activism

On the one hand, activists see themselves as providers of transparency to the market and often trumpet the noble objective of bringing justice to markets and safeguarding investors’ interests. 

 

"The gap in the market that we fill is to say, hey, this management has been bamboozling you investors or misleading you…And here's what's really going on. And this is why we're short.”, says Carson Block, prominent short activist and founder of Muddy Waters Research.(5)

 

Accusations made by short sellers that turned out to be true upon further investigation have led to legal action taken against fraudulent businesses. A report by Hindenburg Research on electric-vehicle maker Nikola Corp. in September 2020 led to founder Trevor Milton being convicted of securities fraud, revealing that the company had faked a video demonstration of one of its electric vehicles by rolling it down a hill.(6)

 

However, some of these accusations have been unfounded. While activist short sellers often present their findings as research (many of them even including “Research” in their names), they stand to profit if the target company’s stock price falls. This naturally results in perverse incentives, since the release of short seller reports tends to elicit huge negative share price reactions on the very same day. Research shows the public announcement of short selling campaigns is associated with negative abnormal returns for targeted companies of -7% on average from the report's publication date.(7) This allows short sellers to exit their positions and profit handsomely even before the public has time to process these reports and verify the accuracy of their allegations. 

 

Thus, the main criticism against activist short sellers is that they are predatory profit seekers who carry out “short and distort” campaigns to spread false negative information deliberately. In 2008, real estate developer Nicholas Marsch hired Barry Minkow to launch a campaign against the housebuilder Lennar Corp. to pressure the company to pay money claimed by Marsch.(8) Minkow allegedly shorted Lennar’s shares and then used online media to spread the message that Lennar was “a financial crime in progress', with the aim of artificially driving down the price of Lennar’s shares. Lennar’s market capitalisation fell by nearly half a billion from this attack. The scheme was eventually uncovered and Lennar won a $1 billion defamation lawsuit against Marsch in 2013.(9)

 

A recent study of 159 cases of alleged fraud by activist short sellers found that only 30% of them resulted in confirmation of fraudulent activity by the relevant authorities.(10) Critics argue that activist campaigns not only mislead investors and increase market volatility, but potentially lead to costly investigations and lawsuits that tarnish even legitimate companies’ reputations permanently.

 

Is activist short selling justified?

My view is that activist short selling is largely justified. When short sellers make truthful claims based on rigorous research and solid evidence, they supply valuable information to correct information asymmetry and improve market efficiency. Without these forensic experts, fraudulent business practices that remain hidden from auditors and market regulators may continue to mislead investors and grow to become even more damaging in the long term. 

 

Moreover, truthful activist campaigns have succeeded in driving widespread changes in regulatory standards to benefit all market participants. It was activist short sellers who sparked the collapse of Enron Corp in 2001 by exposing the company’s financial manipulations, which subsequently led to new standards in corporate governance, accounting and auditing. 

 

Activist short selling remains a justified practice under appropriate regulations to prevent abuse of power and market manipulations. Currently, regulations differ across global markets and range from disclosure requirements and timing mandates around report publications to outright bans. In the EU, UK and US, activist short sellers are required to publicly disclose their short positions above a certain threshold in the companies they target. Both the London Stock Exchange and Italy’s regulator imposed temporary bans on short selling during periods of high market volatility in 2008 and 2020.(11)

 

The case for placing restrictive regulation on short selling should depend on the level of transparency in the market. In opaque markets like China where securities fraud is notoriously rampant due to lax regulations and questionable auditors, it is vital to empower activists to scrutinise and weed out shady businesses. On the other hand, stricter regulation may be appropriate in a more transparent market such as the US. Ongoing debate continues to revolve around striking a delicate balance in regulation that harnesses the potential of activist short sellers to uncover wrongdoing while mitigating the harmful risks of their actions. 

 

As John C. Coffee Jr., director of the Center of Corporate Governance at Columbia Law School , aptly describes, activist short sellers are like vultures11. Just as vultures help maintain the health of ecosystems by consuming carrion to prevent the spread of diseases and pathogens, activist short sellers bankrupt “dead” companies to promote integrity and efficiency in markets. At the same time, both tend to be seen in a negative light due to their predatory natures, as birds of prey and as unethical profit seekers. As John observes, activists should “feast only on truly dead carcasses (companies).”

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