Saints, Sinners and ‘Soul in the Game’: Activist Short-Sellers Continue to Divide Opinion

James Bowden
Aug 27, 2017 · 4 min read

As Gene Wilder’s character, Leo Bloom, informs us in the classic 1968 film The Producers; “it’s simply a matter of creative accounting”. Nowadays it might not just be the unexpected success of Bloom’s musical ‘Springtime for Hitler’ that thwarts his well-laid plans, but activist short-sellers forensically scouring company filings for their next big scalp.

The emergence of short-selling activists in recent years is causing concern for boards around the globe, and the mauling of Australian firm Quintis’ share price by US-based Glaucus in March this year has taught us that even exchanges considered to be ‘safe’ are now playing fields for short-selling financial market ‘vigilantes’ intent on exposing alleged financial misdeeds, and making a tidy buck in the process. Quintis is due to begin trading this Friday following a lengthy voluntary suspension, and will look to pick up the pieces after it’s share price plummeted 82% in the aftermath of Glaucus’ attack.

A study I co-authored earlier this year uncovered an almost instantaneous shift in investor sentiment towards a firm subject to a short-seller activist’s damning research note. It also raised questions about the ability to discern fact from fiction, and free speech from attempted share price manipulation. The somewhat vague answers by then-SEC Chair Mary Jo White during a Bloomberg interview in 2015 illustrated the struggles regulators face in dealing with this predicament; attacks are becoming more common, and ascertaining who the ‘bad guy’ in each individual case takes time. In an online environment within which information (and misinformation) can be rapidly disseminated and incorporated into a firm’s share price, time is in short supply.

Saints or Sinners?

The act of ‘short-selling’ pertains to a four-stage process of borrowing shares from a lender, selling those shares on the market, buying those shares back at a later date, and passing those shares on to the lender. The short-seller is driven by the belief that the share price will drop in the time between selling the shares on the market, and buying them back; Thus, realising a tidy profit.

Traditionally, this role has been taken on by ‘gentleman’ short-sellers, who “short something and shut up”. But recently, these silent assassins have been overshadowed by their much louder counterparts, who “sell short, then go public”, shouting their positions from the rooftops in a form of public shaming. Detailed research notes containing forensic examinations of company accounts are typically published online, and are rapidly disseminated amongst online networks by their readership.

Critics propose that these research notes are not always accurate, usually unsupported by evidence and concerned primarily with profit for themselves (and a favoured few) at the expense of most shareholders. Proponents, on the other hand, argue that short-sellers identify financial misconduct and governance failings and by doing so constitute “the policemen of the financial markets”.

Brian Stoffel at The Motley Fool frames the role of short-sellers in society using Nassim Taleb’s idea of ‘soul in the game’; an individual takes on risk of limited potential gain at the cost of unlimited potential loss. In doing so, society is exposed to risk of limited losses, with potentially unlimited payoff. By putting their soul in the game and accepting individual risks, short-sellers accept potentially unlimited losses (there is no cap on how high a share’s price can go) with the benefit of taking out firms undermining market efficiency and ensuring that capital is channelled into worthy enterprise. Though this is perhaps a little romanticised, it does capture the sentiment of notorious investors such as hedge fund manager Seth Klarman, who claims that activist short-sellers “protect the unsophisticated from predatory schemes that regulators and enforcement agencies don’t seem able to prevent.”

A working paper published by Xiaoran Ni and Sirui Yin, however, finds that firms react to short-selling threats by taking on less risk by holding more cash, taking on less debt, and undertaking fewer mergers and acquisitions. Assuming that compensation is performance-based, this could result in a reluctance by managers to place ‘soul in the game’ themselves, to the cost of both shareholders and long-term economic growth.

Fact, Fiction, Free Speech

In the midst of this argument, arguably occupying a position from which they cannot win, lie financial regulators; challenged to address what corporations perceive as a potential threat, while also recognising the positive impact of short-selling in the markets, and not sending out a message that it will “shoot the messenger” of governance failings and corporate fraud. Considering that short-sellers often attack overseas targets, the complications surrounding international jurisdiction further muddy the waters.

The call by the SEC for improved disclosure of short positions, seems to indicate the route that regulators intend to go down. This approach, however, has drawn harsh criticism from commentators such as Bloomberg columnist Stephen Gandel, who draws comparison with “a government that says it’s fine with free speech as long as it is constantly able to spy on all of your conversations”. The ‘successful’ destruction of Quintis’ share price also suggests that disclosure is not in itself a deterrent (Australian regulator ASIC reports aggregate self-disclosed short positions on a t+4 basis).

For now, as Daniel Yu — the mysterious figure behind renown activist Gotham City Research — claims, “ just as Batman catches criminals (and then submits them to authorities) using little more than his wit and some nice gadgets” activist short-sellers will continue punishing ‘creative accounting’ in their self-appointed role as policemen — for better or worse.

)
James Bowden
Welcome to a place where words matter. On Medium, smart voices and original ideas take center stage - with no ads in sight. Watch
Follow all the topics you care about, and we’ll deliver the best stories for you to your homepage and inbox. Explore
Get unlimited access to the best stories on Medium — and support writers while you’re at it. Just $5/month. Upgrade