The tell: corporate reactions to short-sellers

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Activist short-selling is a funny term when you really think about it. Unlike activist investor campaigns when someone takes a stake in a business, the short-selling speculator has no direct economic means to influence the company. It’s hard, after all, to ask for say, a board seat, or a new chief executive, if you don’t own any shares.

(Although Chris Hohn of TCI has tried to change this pattern of late. Whether his intervention actually changed anything is up for debate. But that’s another story.)

In fact, the economic relationship is almost the total opposite. The short-seller is relinquishing her economic power with the hope of buying back the shares back at a later date at a lower price. Activists aim to do so not by influencing the company but influencing the the market perception of the company. One of the ways they do this is via a lengthy research document colloquially known as a “short report”. And perhaps, if they’re lucky, some media coverage.

While much academic ink has been spilled on the the efficacy of activist short selling — i.e. how share prices react to short reports — little attention has been dedicated to the corporate response. Which, as you may know, can range from the silent treatment — as is the case with Muddy Waters’ report on digital health insurance broker eHealth — to the aggressive, like it was with a certain insolvent German payments company.

A new paper by Janja Brendel of Humboldt-Universität zu Berlin and James Ryan of London Business School seeks to rectify that.

The two academics studied corporate responses to 351 short-reports published on US-listed companies between 1996 to 2018 in an attempt to discover if a company’s reaction is as important as the market’s when a report is released.

There are lots of good tidbits in the paper which caught our attention. For instance, companies have responded to just under one-third of activist short-sellers in the past — the rest giving the silent treatment. And perhaps, of greater surprise, despite feeling like there’s a short report published every week at the moment — on average only 35 reports were published a year between 2010 to 2018. (In the prior period it was a meagre 2.5 reports per annum, which does demonstrate the practice’s increasing popularity.)

However we think the biggest takeaway from the paper is this: beware companies that launch internal investigations in response to a short-sellers’ allegations. Particularly if the investigation is launched by the board of directors.

Via the research:

We expect that initiating an internal investigation to determine the true state of the firm is a significant negative signal, as it implies that the firm’s directors are not sufficiently confident in management to trust that the existing disclosures and management representations are accurate. Such a response is more likely when there are more severe allegations and for firms with foreign operations, which are presumably more difficult for directors to oversee. We find that internal investigation announcements are strongly associated with enforcement actions, a lower likelihood of acquisition, and a higher rate of begin delisted.

In recent history, think of Wirecard’s infamous KPMG special audit into various allegations over its accounting. Or, in the past, Puda Coal’s investigation into claims of fraud by short activist Alfred Little on Seeking Alpha. (Claims which, we should add, turned out to be prescient.)

But just how much of a red flag is an investigation? Here’s the paper again:

We find that when activist short seller targets announce internal investigations, the disclosure is associated with a 383 percent greater chance of a fraud finding . . . and a 61 percent lesser chance of being successfully acquired as an exit strategy, compared to the whole sample of targeted firms.

So how should a company respond?

On Monday we asked LBS’ Ryan, just that, and we were interested to hear his answer since he is currently both a director and chairman of the audit committee at space-travel company (and Alphaville favourite) Virgin Galactic.

He told us we should take the example of corporate glacier General Electric, and how it dealt with a short report in 2019:

A year ago GE was attacked by Harry Markopolos and in my opinion, the company did everything right. It put out their own analysis of the allegation and it went away pretty much overnight. The key was it didn’t attack the short-seller apart from saying ‘this analysis is wrong’

In fact, GE’s response was so good that Markopolos ended up deleting the website he hosted his exhaustively erroneous 170-page report on. It also helped GE that other activist short-sellers, including John Hempton of Bronte Capital and Citrus Research’s Andrew Left, were none too impressed with the work of the man who spotted Madoff.

Yet really the issue here is if the short report is correct. If it’s not, as it was with GE, then it’s easy to respond. If it is, then the company clearly has a problem particularly when the accusations revolve around fake assets, revenues and mysterious foreign subsidiaries.

However when it becomes an issue for the share price, as we’ve seen with Wirecard, is another matter all together.


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