The activists are coming

Tuesday, 01 August 2017


    The global rise in attacks by activist short sellers means boards and executive teams should be prepared. Ben Power reports.

    On 22 March, US-based hedge fund Glaucus Research uploaded to its website a vicious, forensic, 39-page report on Australian sandalwood producer TFS Corporation.

    Coincidentally that same day in Melbourne, TFS hosted a glittering function to launch its rebrand as Quintis. Star guests including cricketer Adam Gilchrist and Formula 1 driver Daniel Ricciardo attended the event.

    The Glaucus Research report, which triggered a Quintis price crash and corporate turmoil, marked the first major assault on Australian soil by a new breed of hedge funds known as activist short sellers. These are investors who bet against a company’s stock and distribute detailed analyses to publicise their position.

    Activist short sellers have been terrorising companies in the US and Asia, and Australian managers and directors can expect more Quintis-like attacks here. “We are definitely actively researching [other] Australian companies,” Glaucus’s Austin, Texas-based director, Soren Aandahl told Company Director.

    The Quintis saga highlights the need for management and boards of Australia’s listed companies to prepare for short selling attacks.

    “It’s inherently an attack on the stewardship of the relevant board,” says Sarah Turner, a partner at law firm Gilbert and Tobin. “They are criticising the performance of the board and the practices of the company.”

    In one sense there is nothing new about short selling in the Australian market. Sophisticated investors have long borrowed shares and sold them on the market hoping to profit from a fall in share price. The short seller buys the shares back at a lower price and returns them, pocketing the difference.

    “Short selling has always been part of the market,” says Carole Comerton-Forde GAICD, a professor of finance at the University of Melbourne.

    But relative to the US, shorts form a small part of the Australian market. Comerton-Forde notes short sellers represent just 13 per cent of market activity here, compared to 40 per cent in the US.

    While short selling isn’t new in Australia, Comerton-Forde says activist short selling is.

    Short sellers using the traditional approach – dubbed ‘gentleman short selling’ – have often lurked in the background. But activist short sellers aggressively promote their thesis, hoping to materially affect their target’s share price.

    Josh Black, the New York-based editor-in-chief of Activist Insight, which provides information about activist investing, says activist short selling campaigns have more than doubled globally, from 111 in 2011 to a peak of 271 in 2015. Some 270 campaigns were launched last year, and 96 attacks have occurred this year. But activity in Australia has been negligible, with just three attacks in both 2015 and 2016, and two this year.

    Aandahl says Australia is an attractive market for activist shorts because it is a large, liquid market with a strong rule of law. But he says what makes it most attractive is a culture of failing to question management and boards.

    The emergence of activist short sellers on our shores comes amid rising shareholder activism, with the likes of BHP Billiton facing aggressive campaigns.

    Impact on market

    While most activists agitate for change to drive share prices up, short sellers profit from destruction of shareholder value, which makes them particularly loathed by management.

    Retailer Gerry Harvey has slammed short sellers as market cowboys with a license to kill, who are trying to destroy share prices. Mining entrepreneur Andrew Forrest has labelled the practice almost criminal. Both their businesses, Harvey Norman and Fortescue Metals Group, have been subject to recent short selling campaigns.

    But Comerton-Forde says evidence suggests short sellers benefit markets. “Shorts do make the market more efficient, and also provide liquidity,” she says. She also notes that, on average, shorts are right: researched published in The Journal of Finance found heavily shorted stocks underperform lightly shorted stocks by approximately 15 per cent a year.

    Aandahl says short sellers are a maligned part of the market, but bring transparency and accountability. While studying at Harvard Law School, Aandahl worked on the US Justice Department’s prosecution of Enron executives who were responsible for one of history’s biggest accounting frauds.

    “That really started a fascination with how public companies misrepresent finances and engage in malfeasance,” he says. Aandahl notes that famed short seller, Jim Chanos, was the first to highlight Enron’s issues.

    He suggests that Australia’s high level of corporate governance makes the rotten apples stand out even more.

    Glaucus targets management that misleads investors about financial or operational performance. Its Quintis report alleged the company operated a Ponzi-like structure and valued its shares at zero. Sandalwood, which is used in incense, perfumes and traditional Chinese medicines, takes up to two decades to grow, Glaucus noted, meaning cash flow is difficult and Quintis relied on capital raisings to pay debt and investors.

    A spokesman for Quintis, which issued a public rebuttal of the report in an ASX announcement, says the company would not comment further on the issue.

    But he pointed to an earlier statement: “The [Glaucus] note is a self-serving and biased note by a shorter of the stock in an attempt to drive TFS’s share price down for their own financial gain.” Quintis added there were “substantial and egregious inaccuracies littered throughout the note”.

    The role of regulators

    An ASIC spokesman says the regulator is keeping a close eye on the activity of activist shorts. At the height of the global financial crisis in September 2008, ASIC temporarily banned short selling in a bid to reduce market volatility. A ban on ‘naked’ short selling, where investors don’t borrow stock, has continued.

    ASIC has also tightened reporting requirements. Short sellers, for example, must report their net short positions to ASIC on T+3 basis if their position is larger than $100,00 or 0.01 per cent of issued capital. Comerton-Forde says those reporting requirements are high compared to the rest of the world.

    A strong regulatory crackdown on activist shorts in Australia is unlikely, which means companies and boards need to start thinking now about how they can best defend a short attack. This begins with monitoring.

    ASIC’s reporting requirements mean Australian corporates have good information on the build-up of short positions in their stock. But an activist short attack is sudden. Gilbert and Tobin’s Turner notes they are carefully planned and coordinated with an element of surprise to maximise their impact. The information, usually via report, can gain immediate traction in the media when issued and can put the company on the back foot.

    However companies can be awake to trouble brewing. A red flag is disclosure criticism, Turner says. Another red flag is pointed and aggressive questioning during an investor conference call, and changes in the shareholder base, according to Peter Brookes, joint managing director of investor relations firm Citadel-Magnus.

    Activist Insight’s Josh Black says that of the 997 companies targeted by activist short sellers globally since 2011, some 238 have responded, “usually by issuing a rebuttal, but occasionally seeking to sue.”

    Responding to an attack

    The ferocity of the activist attack can trigger emotional responses and lead management and directors to attack the short sellers themselves. “That’s a huge mistake,” Aandahl says. “Independent directors need to recognise that as professional investors we have spent 500 to 700 hours on our ideas. There is a lot of thought and research behind it.”

    Turner also counsels against accusing short sellers of short termism. “A calmer head is often the more compelling voice,” she says. “You don’t want to react too hastily and end up on the wrong side of the ASX or in litigation.”

    It is understood some companies believe they have their hands tied behind their back because short sellers, particularly foreign activists, aren’t subject to the same laws as locals. But short sellers – including foreign ones – are subject to defamation laws and the Corporations Act, which legislate against market manipulation and false or misleading statements.

    Turner says that while legal action is an option for Australian companies, the likes of Glaucus actually operate on a strong legal footing.

    Of legal action, Aandahl says “bring it on”. Glaucus is not worried, and legal action can uncover new information for the activist short seller. “We don’t speak on something unless we have a totality of documentary evidence supporting us,” he says. “We’re happy to litigate in a court of law.”

    Turner says that means good corporate performance is the best defence. She also warns against aggressive guidance or encouraging investors or analysts to overvalue your company, and suggests companies should get bad news out as early as possible.

    Citadel-Magnus’s Brookes says investor relations is vital to preventing an activist short campaign. He says a company needs to build and maintain credibility with shareholders and analysts and look to attract the best long-only funds who are sticky to their share register.

    “A big part of this is having a compelling story around environmental, social and governance issues,” he says. “The shorts will simply leave these companies alone because they have their house in order and a compelling story to underpin it.”

    Aandahl cites the adage that an ounce of prevention is worth a pound of cure. “The more companies are transparent and honest with disclosure, the more transparent they are about their business and finances with the market and investors, the less likely they have to worry about an investor with a short thesis on them,” he says.

    Glaucus seems to have made the right call on Quintis. Since its report and at time of writing, the stock has crashed 78 per cent. The company disclosed an oil supply contract between its subsidiary Santalis and Nestle-owned subsidiary Galderma was terminated in December 2016, without the Quintis board’s knowledge, which shook investor confidence.

    Quintis co-founder and managing director Frank Wilson has quit to pursue a takeover bid, and at time of writing the company’s shares were suspended at 30c as it looks at potential debt and equity transactions.

    Glaucus no doubt hopes to profit from targeting other Australian companies. But Aandahl believes that his efforts will benefit the market more broadly by acting as a deterrent. “Australian management teams thinking about doing what Quintis did would think twice about it,” he says.


    • Consider a trading halt
      Sarah Turner, a partner at law firm Gilbert and Tobin, says an activist short attack is a detailed statement of why your stock is overvalued. The obvious response to that is a detailed, compelling response. “If you can’t get a response out immediately, you don’t want your stock trading with that position unanswered.”
    • Engage external advisers
      Given the complex nature of short selling attacks involving compliance, shareholders and media, Turner says boards should engage legal advisers and investor relations firms with experience in dealing with short selling attacks.
    • Launch an independent review
      Soren Aandahl, director of activist short seller Glaucus Research, says the best response for directors is to immediately take the short seller’s thesis to independent sources, such as an independent auditor or accountant not connected with management. Ask them to look at the claims with an objective eye and advise on what to do next.
      Turner recommends companies form an interim committee of independent directors and company advisers to assess the activist’s claims so they can issue a punchy response in a timely manner. The committee can include independent voices. “An independent review might be too slow in and of itself,” she says. But after reviewing the activists’ claims, the interim committee might refer concerns onto an independent committee.
    • Ramp up shareholder and media communication
      Peter Brookes, joint managing director of investor relations firm Citadel Magnus, says if activist short sellers are using the media, any misinformation needs to be dealt with quickly. “The CEO has to be visible and on the front foot with investors and media,” he says.
    • Consider corporate actions
      Turner says companies need to get on the front foot. “Consider whether it is possible to bring forward initiatives such as announcing a dividend, share buy-back or other corporate transaction that might have a positive impact on the share price.” But she cautions that any initiatives must be made in the best interests of the company as a whole.
    • Keep running the company
      Turner says management and boards shouldn’t get distracted from running the company. “Good performance, demonstrated by meeting or exceeding expectations in earnings and revenue, is the best response.”

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