Scourge of the market

A board learns about an aggressive short-selling campaign in the company’s securities through a finance newspaper gossip column. An activist hedge fund has written a scathing report on the company’s governance and performance, and leaked it to the media.

The goal is obvious: attract attention to the report, destabilise the company and profit from a fall in its securities through short-selling. The hedge fund stands to make millions as the share price tumbles and negativity on the stock intensifies.

The company responds predictably. The CEO discredits the hedge fund report, without addressing specific allegations. He claims the hedge fund is deliberately starting false rumours, to drive the price lower, and bemoans the practice of short-selling on ASX.

But the hedge fund is well informed and parts of its investment hypothesis are correct. Core shareholders study the activist report. A share price in freefall raises questions about the company’s solvency and long-term future.

The board soon responds to the short-seller’s concerns. The company discloses that some aspects of the hedge-fund report, such as concerns about delayed contracts, are correct. In effect, the company has breached continuous disclosure obligations and is now vulnerable to a shareholder class action. Investors are lining up to force board change and sue for damages.

This short-selling scenario is, thankfully, still limited on ASX. Most short-selling campaigns do not lead to board change, continuous disclosure breaches or shareholder class actions. But there is little doubt that boards need to pay extra attention to short-selling campaigns.

We will see an increase in short-selling in Australia in the next few years,” says Dr Ulysses Chioatto, adjunct associate professor of law at Western Sydney University. “Local and offshore activist funds will use short-selling as a disruptive mechanism to target companies with governance issues.” Chioatto is a former head of Institutional Shareholder Services, a leading global proxy adviser, in Australia.

Chioatto says short-sellers, a form of shareholder activist, are attracted to companies with poor governance. “It’s a bit like wolves chasing a herd and looking for the weakest animal at the back of the pack. If the company has any chink in its governance or operational performance, there are activists lining up to pounce on the stock and its board.”

Like or loathe it, short-selling is well established in Australia and offshore exchanges. The practice allows investors to profit from a negative view on a listed security.

Typically, a broker lends stock to a short-seller from the firm’s stock inventory, another firm or large client, such as an institutional fund. The shares are sold, funds are credited to the investor and at some point, they must close out the short position by buying back the same number of shares and returning them to the broker.

If the price falls as the short-seller expects, they buy the stock back at a lower price and pocket the difference. If the price rises, the short-seller must buy back at a higher price and loses money. Some stocks rally when short-sellers are forced to buy at higher prices.

Short-selling critics say the practice is a blight on investment markets and against the spirit of stock exchanges, which are there are to help companies raise equity capital and grow. Some critics claim a conflict of interest between “long” funds on the share register (those with a positive view), who lend their shares to short-sellers, to earn extra income.

Short-selling proponents says the practice aids price discovery, improves stock liquidity and lifts superannuation returns by providing income from securities lending. Different views make a market and short-selling counteracts inflated company valuations, they say.

“Nobody complains when market participants who have a buy recommendation on a stock are out there aggressively promoting a positive view,” says Michael Gallagher, MAICD, director of the Alternative Investment Management Association, Australia – the peak body for hedge funds. “But some people are up in arms when a fund dares to promote a negative view on a stock, even if that view is on the money.”

Gallagher, chairman of the ASX-listed Fat Prophets Global Contrarian Fund, adds: “If boards spent as much time understanding the concerns of the 10 per cent of investors who are shorting the stock, and have a legitimate contrary view, rather than only the other 90 per cent who have a positive view, governance would improve.

“There is significant scope for companies to improve their communication with short-sellers and learn about their views; the best activist funds do a mountain of research on stocks and often have insightful, fresh opinions. Yet we only hear criticism of short-selling from boards.”

Harvey Norman Holdings executive chairman, Gerry Harvey, is a vocal critic. The veteran retailer stepped up his attack on short-sellers in March, reportedly declaring them “criminals” who use deceptive tactics to decrease the share price and manipulate shares.

He claimed short-sellers had formed allegiances with proxy advisers and sections of the local media, and called on the Australian Securities & Investments Commission (ASIC) to investigate. Few chairmen have publicly raged so hard against short-selling.

Another ASX-listed company, Quintis, (formerly TFS Corporation) recently felt the brunt of short-sellers. The sandalwood producer in March described an analysis by Glaucus Research Group as “self-serving”, “biased” and “an attempt to drive TFS’s share price down for their own financial gain”. It claimed the note had “substantial and egregious” inaccuracies.

Within days, Quintis provided a detailed response to the short-seller’s research, in response to an ASX query. Managing director Frank Wilson resigned a day later, saying he had received an offer to partner with an unnamed international corporation to present a proposed change of control transaction in Quintis.

Slater & Gordon is another prominent example of the effects of short-selling. Local hedge funds in 2015 attacked the listed law firm, believing it was overvalued and had overpaid for its United Kingdom acquisition – a view since validated by Slater’s troubles.

In an interview with Company Director in July 2015, Slater’s board attacked short-sellers for leaking what the company claimed was “false information, rumours and innuendo”. The implication was that short-sellers had manipulated Slater’s securities.

A recurring allegation against short-sellers, more anecdotal than proven by empirical research, is that some hedge funds deliberately spread false rumours in the market and financial press to drive a share price lower and profit from a short position.

Clearly, boards need a measured approach to short-selling and perspective on this issue. For all the hype, short-selling remains reasonably limited on ASX compared to offshore markets. Academic research in 2012 found short-selling accounted for 40 per cent of the dollar value traded in US equity markets, compared to about 13 per cent in Australia.

This market, arguably, does not have the scale to attract the largest activist hedge funds, although Elliott Management, a US fund, in April 2017 called on BHP Billiton to spilt off its petroleum business and restructure the business – a rare public activist intervention at the top end of corporate Australia and possibly a sign of things to come.

Also, higher board standards and corporate transparency in Australia compared to most offshore markets may be a natural deterrent for activist hedge funds that seek to exploit governance weaknesses through short selling.

ASIC’s aggregated short positions report table in April this year shows only 11 of 463 stocks had a short position of more than 10 per cent. Put another way, the clear majority of investors in these companies have a positive view on the company.

Even so, there are several reasons for boards to pay extra attention to short-selling as part of their organisation’s investor relations and shareholder engagement strategies.

The first is expected growth in short-selling by activist hedge funds in Australia. United States funds, such as Glaucus Research, have set up in Australia this year and more are expected to follow.

Unlike traditional short-sellers who are often secretive, activist short-sellers may prepare detailed research notes on companies and make them widely available. The research may cast doubt on the company’s financial accounts and the credibility of management and the board. The activist’s views are often promoted to the financial media.

Social media means bad news travels faster than ever and is accessible to a global audience. Largely unknown activist funds in Australia this year have been able to generate significant publicity for their negative views on stocks, even though they might own less than 1 per cent of the company’s securities and have unknown research credibility.

Continuous disclosure obligations are another reason boards should understand if their organisation’s share register contains activist funds and the short position in its securities.

Although boards are quick to discredit activist views, such funds are often well-informed and capable of producing insights that buy-side investors may not have considered.

Short-sellers do not always get it right, but the market’s 20 most shorted stocks include many companies facing disruption in their industry, or those that have had negative publicity around operational or governance issues. In many cases, short-sellers have been correct.

Chioatto says: “Those who are shorting companies generally seem to be a bit better informed than investors who take a long position and hold the same stock for years. If you look through ASIC’s list of the market’s most shorted stocks, there are plenty of challenged companies that have good reason to be on that list.”

Boards must ensure the activist’s research has not identified issues that the company has not disclosed; information that a reasonable person would expect to have a material impact on the entity’s securities and thus must be disclosed to ASX under Listing Rule 3.1.

Companies must further ensure the activist fund has not created a false market in the entity’s securities. Under Listing Rule 3.1.B, ASX can require a listed entity to provide information immediately, to correct or prevent a false market, if ASX considers there is a false market in the securities.

Simply, companies need to monitor the activist’s research and ensure there are no disclosure implications or false markets being created in its securities, through misleading or inaccurate research, rumours or other types of market manipulation.

“It can be very hard for companies to counteract what is in the activist’s report,” says Chioatto. “If the company aggressively challenges the report, or goes into detail to disagree with its finding, it could pour petrol on the flames and open the company to continuous disclosure breaches and class actions, which have implications for boards. Instead they opt for a strong denial, which is weak on detail.”

The potential for short-sellers to link with litigation funders – firms that finance shareholder class actions – is another governance threat. Shareholder class actions and limited regulation of litigation funding in Australia have become major governance concerns this decade.

There is nothing legally to stop activist funds from bankrolling class actions in Australia and attempting to profit through short-selling. The announcement of a high-profile class action can weigh on a share price, providing scope for short-sellers to benefit and more motivation for companies to engage in early settlement of such actions, even some with lower legal merit.

“The unregulated environment for litigation funding in Australia could see a hedge fund finance litigation against a stock that it was also short-selling,” says Associate Professor Michael Legg, a class actions and litigation funding expert at UNSW Law. “The restriction from a funding perspective would be the Corporations Regulations (2001) requiring that conflicts of interest be managed. But that would not prohibit the practice.”

Legg says it might be possible to put systems in place to separate the class action funder (the activist hedge fund) from the legal team running the case. “The lawyers would have to act in the best interests of the class action’s members, and the activist fund would need to be quarantined from influencing that. But the activist would still benefit if the company’s share price fell.”

Legg says hedge funds have bankrolled litigation in the US and are showing greater interest in litigation funding, a unique asset class. “The activist fund effectively gets two bites of the cherry: a potential high return from funding the class action and another return from short-selling the company’s securities,” he says.

“Intuitively, one can see the link between activist funds, short-selling and litigation funding. The activist adopts a short-selling position because they believe the share price is overvalued, presumably because the market is not fully aware of information. This is fertile ground for class actions if it is proved that the company should have disclosed the information.”

Legg says the potential for large activist funds to bankroll class actions is another reason for boards to ensure their organisation has and uses best-practice disclosure policies and procedures, analyses their share register and ensures they know who is funding the class action (which must be disclosed pursuant to court practice notes.)

“Boards need to be aware of the legal risks when their organisation is targeted by activist short-sellers and include an extra element of due diligence,” Legg says. “They need to understand who is behind the short-selling and why, and if activists are involved in any resulting class action.”

Arnold Bloch Leibler partner, Jeremy Leibler, says good governance and clear market communication is the best defence against activist short-sellers. He is one of Australia’s leading legal advisers in shareholder activism, having advised activist groups as well as companies that are under attack.

Leibler says companies should address the underlying reasons for short-selling in the company’s stocks, assuming there is no market manipulation. “Why are investors forming a negative view and why are other shareholders, who have a positive view, willing to lend their shares to short-sellers? Management and the board need to know if the market believes there are performance issues in the company, assess if those concerns have merit and, if so, do something about them.”

Leibler says chairmen ranting publicly about the evils of short-selling is misguided. “All it does is bring more publicity to the activist campaign and increases the volume of short positions in the stock. Companies should approach the larger short-sellers in the same way they approach other activists: meet with them, understand their concerns, put the company’s investment case to them and attempt to counter views it disagrees with.”

The big shift in activist short-selling, says Leibler, is the willingness of prominent Australian fund managers to get involved. “The mainstream funds are siding with activists when they believe there is a strong case for change in a company. The activist who has 1 per cent of shares might effectively speak for shareholders who own 40 per cent of the stock,” he says.

“That presents a hypothetical dilemma for boards, which must weigh up the interests of all shareholders, some of whom have very different return objectives, in any change of control.”

A best-practice investor relations program is critical to safeguard against shareholder activist campaigns. Chioatto says boards should ensure their organisation has a clear "investment narrative" to help combat activist campaigns.

“Often, the investment story is inconsistent or, frankly, a dog’s breakfast. With investor communication, too many boards focus mostly on shareholders who have a positive view on the stock. They ignore investors who have a negative view.”

Chioatto adds: “Increasingly, boards will have to understand the views of long and short investors, and understand how their positive and negative views align with the company’s investment narrative. If there is genuine misalignment, the company needs to do something about it quickly.”