Introduction
Activist short selling is a consequential and prominent feature of global financial markets. Short selling is the practice of selling financial products that one does not own, with the intention of repurchasing them later at a lower price. In simpler terms, it is a bet that the price of a security, such as a company share, will decrease by a specified date. What sets activist short selling apart is the public dissemination of this position and the potential reasons behind it.
To fully comprehend activist short selling, it is essential to examine key examples of institutional short sellers. Hindenburg Research, one of the most famous and influential short sellers, actively scrutinizes large corporations with a dual purpose: uncovering lucrative short positions and reporting the reasons behind them. Another major player in this field is J Capital. It’s important to note that while large organizations play a significant role, market movements can also result from consortiums of smaller, everyday investors.
The other side of the activist short selling story involves the corporate targets of these positions. A recent example is the Adani group, an Indian resources conglomerate with major interests in coal, ports, and natural gas. In January 2023, Hindenburg Research released research claiming that Adani had engaged in a “brazen stock manipulation and accounting fraud scheme over the course of decades.” This led to a staggering $104 billion loss in Adani’s stock valuation, legal action, and a decline in consumer confidence. The effects of activist short selling were further exemplified by Hindenburg’s attacks on Icahn Enterprises, a holding company known for corporate raiding. Hindenburg claimed that “IEP units are inflated by 75%+,” leading to calamitous consequences for Icahn. These instances highlight the potent impact of publicly disseminated activist short selling.
Activist short selling has gained increasing importance due to its proven ability to move markets and even strike down large firms like Hindenburg and J Capital. However, concerns arise that these reputable firms may manipulate markets to profit from short positions. Market manipulation poses a fundamental risk to confidence and market efficiency and must be treated as a grave threat. On the other hand, proponents argue that activist short selling has exposed overvalued and potentially corrupt businesses, ultimately increasing market effectiveness. It is worth noting that the majority of major activist short positions have exposed immoral activities, enabling investors to make better-informed decisions. The moral righteousness of activist short selling ultimately depends on the organizations employing it.
Activist short selling carries both benefits and risks for financial markets. On one hand the investigative practices inherent to activist short selling are crucial in providing accurate information about the performances of many companies. This information is made available to the public in one of two ways: either short sellers directly publish their findings alongside their intention to short the stock in questions, or this can happen indirectly, through short sellers advising media outlets of a potential story or a route for further investigation. The fact that short sellers stand to gain significantly financially as a result of bringing new information to the market creates substantial incentive to uncover such information – important as firms often take steps to hide their malpractice from the public eye.
Further, increased short selling can also lend liquidity to markets, primarily observed through improving bid-ask spreads and price impacts. If short selling were to be restricted or discouraged, this would prevent informed short sellers from trading on negative fundamental information – reducing price efficiency and increasing the likelihood of pricing errors.
However, on the other hand, there are a number of drawbacks to short selling. The first is that they can create panic and volatility through market manipulation. As activists stand to gain from a substantial price drop, they may have a tendency to exaggerate aspects of a company’s overvaluation, leading to an overblown price drop. Such behaviour draws accusations of activists peddling a ‘pump and dump’ scheme in reverse. The effect on volatility has led some regulators to institute restrictions on short selling during financial crises.
Additionally, some of the methods short sellers use to uncover information can be immoral, or simply illegal. For example, Carson Block, a prominent short seller, admits to impersonating others, and his other methods have led to investigations from the FBI and Department of Justice.
Since activist short selling presents both benefits and risks, it is crucial to examine individual cases within their specific contexts, rather than attempting to reach a verdict on the intrinsic value of the practice itself. However, to ensure a net positive impact, regulatory oversight is critical.
In this context, the Australian Securities and Investments Commission (ASIC) provides best practices in activist short selling that could help mitigate potential risks. This includes releasing Short reports outside of market hours – as opposed to immediately before the start of trading – to enable investors to assess the credibility of information, helping to reduce volatility in markets. Additionally, to avoid misinformation, Short reports should be fact checked with the target entity and based on reasonable and informed opinions. Finally, any conflict of interest must be disclosed -in practise this generally means disclosing that the publisher of the report has some kind of short position in the target entity so that other investors are aware of the purpose of the report and can approach it with appropriate scrutiny.
Moreover, activist short sellers must face the same litigation risks as regular investors, ensuring appropriate legal avenues for pursuing misinformation. For instance, when J Capital released a report containing allegations about Vulcan Energy (ASX:VUL), a renewable energy and lithium producer, Vulcan sued J Capital for unfair comparisons, false cost comparisons, and misidentification of involved parties. The subsequent apology and out-of-court settlement underscore the importance of accessible legal avenues in countering misinformation.
Notably, ASIC has the power to engage with the activist short seller on matters such as testing the veracity of claims, the process and timing of the report’s release, and disclosure of conflicts of interest. They also have the ability to halt the trading of a security and pursue any legal action in the case that the law is breached and engage with the activist’s home regulator should they be situated abroad. The maintenance and strengthening of these guardrails are likely to be crucial in preserving the integrity of financial markets as activist short selling gains prominence.
In conclusion, activist short selling can be a powerful tool for the benefit of financial markets, but it must be used responsibly and with proper oversight. By adhering to best practices and establishing mechanisms for accountability, the risks associated with activist short selling can be mitigated, allowing it to contribute positively to the financial sector.
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
