Insight - Scourge or market mechanism?

The Governance Leadership Centre considers the implications of short-selling for boards and its implications on company performance.

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, destabilise the company and profit from a fall in its securities through short-selling. The hedge fund stands to make millions.

The company responds predictably. The CEO discredits the 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 solvency and long-term future.

The board soon responds to the concerns. The company discloses that some aspects of the 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 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 MAICD, 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.”

Short-selling in action

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, the short-seller buys the stock back at a lower price and pockets 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.

A divisive practice

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.

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.”

Harvey Norman Holdings executive chair, 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 ASIC to investigate. Few chairs have publicly raged so hard against short-selling.

A recurring allegation against short-sellers, more anecdotal than proven by empirical research, is that some hedge funds deliberately spread false rumours 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.

Australian context

For all the hype, short-selling remains reasonably limited on ASX. 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 split 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.

A growing threat

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

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 the expected growth in short-selling by activist hedge funds in Australia. US 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.

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. 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.

A third reason, 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 FAICD, 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 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).

Defend and safeguard

Arnold Bloch Leibler partner, Jeremy Leibler MAICD, says good governance and clear market communication is the best defence against activist short-sellers. Leibler says companies should address the underlying reasons for short-selling in the company’s stocks, assuming there is no market manipulation. “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.”

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 one 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 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.”