Friend or foe? Why short sellers are in the headlines again
When activist hedge fund Quintessential launched a short attack against London-listed tech darling Darktrace in January, the charge sheet was a serious one.
Among a lengthy list of misdemeanours, Darktrace, Quintessential said, had seemingly “simulated or anticipated sales to phantom end users”, repeatedly used marketing activities to “channel funds back into its partners” and may have used “shell companies in offshore jurisdictions manned by individuals with ties to organised crime, money-laundering and fraud”.
The once feted tech giant was thrown. Its share price cratered, bosses scrambled to refute the allegations and comms officials were quickly on the phone to fight the fire.
But when it later called in auditors at EY to try and clear its name, the reality seemed to be some way short of the sordid picture painted by Quintessential.
Aside from “a number of areas” where its systems, processes or controls could be improved, Darktrace said it had been given a largely clean bill of health by the Big Four firm. The shares have since recovered.
It should however be noted it has refused to publish the report in full, and Quintessential has called on the firm to “fully unveil the details of the EY review” and facilitate an “open dialogue on its findings.
“Given the severity of our allegations, we believe this situation warrants a significantly higher level of transparency, which Darktrace has yet to provide.”
‘Important tool’
Even as question marks remain, the spat has ignited a debate over the virtues and pitfalls of short-selling in the UK just as government embarks on a push to overhaul existing rules.
Ministers have touted short-selling as an “important tool” in the market arsenal that facilitates price discovery and allows investors to call out wrongdoing. Under a number of regulatory tweaks, short sellers will have slacker restrictions on disclosures, meaning they do not have to reveal their identity or announce their positions to the market until they cross a slightly higher threshold of 0.2 per cent of issued share capital.
In essence, short selling means investors bet against a company’s share price and rake in hefty profits when it falls. Investors borrow a stock, sell it on and then buy it back on the cheap after the price has plummeted, leaving them with a profit.
Activist short sellers like Quintessential accompany their bets with damning reports seemingly blowing the whistle on things like corporate malfeasance and dodgy accounting. And it is in those reports that the virtues of short selling often come to the fore.
Take the example of Home REIT last year. Prolific short seller Fraser Perring of Viceroy Research blew the whistle on the social housing investor’s shaky foundations and triggered a monumental corporate crumble that has seen its shares suspended and a total overhaul in strategy.
Home REIT made false statements to the market about social purpose. Viceroy exposed them.
However, some argue attacks like the one on Darktrace move into contentious territory. There is no suggestion of nefarious motives in Quintessential’s attack, but some City figures have called for a firmer regulatory hand on some short selling reports that go unproven.
A question lingers however, over how far the watchdogs can really go in clipping their wings.
“Trash and Cash’ is a form of market abuse where the holder of a short position in a security makes or causes to be made a false or misleading negative statement about the issuing company and profits from the resulting fall in share price,” Martin Sandler, a financial services regulatory partner at Eversheds Sutherland, tells City PM
It is extremely difficult for a regulator to prove ‘trash and cash’ motives
“Currently, however, it is extremely difficult for a regulatory or enforcement authority to prove that a statement or report is false or misleading, or even linked to the short-seller or that there was any intent to mislead the market.”
It’s also not true that short sellers always do well out of their positions. Many who took positions against Ocado, a perennial favourite of short sellers, have been faced with a stock up 35 per cent on the year.
The regulator already has a toolbox to deal with the murky world of short attacks. FCA officials can draw on a deep pool of data sources including order book and transaction data when reviewing an allegation of market abuse, while Suspicious Transaction and Order Reports (STORs) filed by regulated firms can also give a glimpse into the structure and nature of any short attacks.
In moments of crisis, too, regulators can put a stop to short-selling. The Fed banned short selling of financial stocks during the financial crisis.
Legally, the watchdog can also demand any information from firms and people it thinks may be connected with market manipulation. It can also initiate both civil and criminal investigations into any suspected manipulation.
But the crux, as Sandler points out, lies in proving any motive to mislead.
For the moment, even with a number of reforms coming through to the UK’s capital markets, short selling will remain as easy to execute as ever in the UK.
“The Treasury is proposing a series of technical changes that should reduce the administrative burden for market participants but would not make it harder for short sellers to target UK companies,” Tom Callaby, a financial services Partner with law firm CMS, tells City PM
“Taking short positions and then disseminating misleading negative information with a view to decreasing the price continues to be contrary to the UK’s market abuse regime.”
Abuse it may be. But whether regulators will be minded to step in is another question.