I think the GameStop phenomenon portends a seismic shift in many areas. It may well be a turning point in markets and investments. Where it will be going, I do not think anyone knows right now but everyone needs to be watching and, more importantly, every Chief Compliance Officers (CCOs) and compliance professional needs to be paying attention. One of the most prescient observations about the Coronavirus health crisis and its impact on business came from Jed Gardner, Senior Vice President at Linedata Technology Services, who said, “we have moved from disaster recovery to business continuity to business as usual during the time of Coronavirus. He explained that risk managers, compliance professionals and business executives now have to plan for the unknown unknowns in their business plans and risk management strategies.”
Is your compliance program flexible enough to manage this change? Can it adapt to allegedly unforeseen crisis which will be with us going forward. The Department of Justice (DOJ) now mandates that a minimum best practice for any compliance program is both continuous monitoring leading to continuous improvement. This type of development is no longer a compliance program “nice-to-have” but a mandatory business practice. On to the shorts.
What is a Short Seller?
Short Sellers (shorts) have been around forever. In ancient Greece, where you could bet on just about anything, shorts bet against rival city-states, thereby driving value down. In more modern parlance, Mark Hulbert, writing in the New York Times (NYT) in 2010, explained that shorts “profit by finding stocks or other securities that will underperform the market”. He went on to note, “Short-selling — borrowing shares and selling them, intending to buy them back later after the price declines — is a divisive issue. Traders who bet on the decline of a company, a currency or even an entire market aren’t always popular. The billionaire investor George Soros was initially pilloried when he bet correctly in 1992 that the British pound would fall sharply.”
Shorts became particularly controversial in the era of the bear market during and after the 2008 financial crisis. As reported by Michael Lewis in his book, The Big Short, many shorts turned a profit while almost all other investors were suffering. This powered many investors long-held beliefs that shorts were manipulating the market to induce the very price declines from which they profit. Moreover, where do shorts get their contrarian information?
Hulbert said, “the average short-seller has done well through astute research and analysis, not market manipulation.” This was based on a study entitled “How Are Shorts Informed? Short Sellers, News and Information Processing.” The authors, Joseph E. Engelberg and Adam V. Reed, both finance professors at the University of North Carolina at Chapel Hill, and Matthew C. Ringgenberg, a Ph.D. concluded, “in a vast majority of cases, short-sellers reacted to news articles when the rest of the market did. What, then, is the source of short-sellers’ historical success? The researchers concluded that the most likely explanation was that short-sellers, compared with other kinds of traders, have a superior ability “to analyze publicly available information.””
Short and Distort
Why then do shorts have such a bad reputation? The answer is simple “short and distort”. Jennifer Detrani, writing in Above the Law, said, “short and distort” is “a form of securities fraud wherein an investor takes a short position on a stock and then publicly berates the stock to influence it to drop.” This is opposed to a “pump and dump” scheme which “involves overpromotion of speculative stocks before selling out at the top. Pumping and dumping works best in a bullish market and shorting and distorting works best in a bear market.” Further, both schemes are potential securities law violations. The elements would include “(1) misrepresentation to the market through articles, blogs, and social media; (2) materiality, especially when false statements discuss a company’s financial condition or viability; (3) an intent to deceive through market manipulation; and (4) connection to the purchase or sale of securities.”
How does a short work? Typically, they take a short position and then announce it publicly. This publicity alone is usually enough to drive the stock down (if the short is big and/or well known enough). Some shorts pump this information out on social media channels explaining how or why they believe a stock is over-valued or over-priced. Do shorts distort the market? There are certainly are many that do so. Is it misrepresentation as noted above? Not if the shorts are wrong about the stock value. But what if the very act of announcing you are shorting a company drives a stock down, especially if your analysis is incorrect? Does this become a misrepresentation? Do you have to explain your reasoning, logic or is a ‘just a hunch’? If a stock goes down after a short announces it is shorting the company, did the stock go down because it was over-valued or because someone cried wolf?
Shorts and the Market
Do shorts aid in the market? Investopedia says, “Short selling strengthens the market by exposing which companies’ stock prices are too high. In their search for overvalued firms, short sellers can discover accounting inconsistencies or other questionable practices before the market at large does.” According to Hulbert, “James S. Chanos, a hedge fund manager, was a lone voice when he began betting against Enron in November 2000, long before the company collapsed”. The same was true about Chanos when it came to the fraud which was WorldCom.
More recently we saw Bill Ackerman make a notoriously famous short selling bet against Herbalife Nutrition. He accused the company of being a pyramid scheme. Herbalife fought back ferociously saying it was a legal multi-level marketing company. Pyramid schemes are illegal, while legal multi-level marketing is, well, legal. Ackman also said that Herbalife was the most well-run pyramid scheme in the world, implying that the fraud they perpetrated was far-reaching and extremely deceptive. It turns out Ackerman was right that an illegal scheme was underlying Herbalife, but that illegal scheme was an entire business unit based on bribery and corruption in China. Was it Ackerman’s short position which led to the Securities and Exchange Commission (SEC) looking into Herbalife as the company did not self-disclose that it was engaged in bribery and corruption? Whatever the reason, the company, according to a DOJ Press Release, “agreed to pay total penalties of more than $122 million to resolve the government’s investigation into violations of the Foreign Corrupt Practices Act (FCPA).”
Join us tomorrow where we look at the Squeeze and social media.
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