Massimo Giachetti /

This article appears in the June 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

When the Canadian Securities Administrators decided to tackle activist short-selling late last year, it was already a thorny topic with the potential to cross over into debates about how information is shared online and even free speech.

Then came the GameStop saga. Retail investors’ surprising demonstration of might earlier this year inflicted huge losses on hedge funds shorting the brick-and-mortar video game retailer, pushing the company’s shares to improbable heights. Investors also showed they can organize online and respond to information in unpredictable ways that have disorienting effects on financial markets.

“With the advent of social media and the GameStop situation, you could imagine that somebody could put information into the market — perhaps not a traditional short report — and if they have sufficient followers, a very little amount of information could have a pretty dramatic effect on a stock,” said Jeffrey Singer, managing partner of law firm Stikeman Elliott LLP’s Toronto office.

Respondents to the CSA consultation took note of the Reddit crowd. The Canadian Investor Relations Institute (CIRI), the industry group representing investor relations professionals at public companies, pointed to wild swings in the share prices of GameStop and BlackBerry this year as reasons for concern. “Their experience illustrates the negative impact activist short-selling has on market efficiency and price discovery,” the CIRI submission said.

As regulators determine the extent of the problem posed by activist campaigns and whether new rules are needed, the potential solutions aren’t getting any simpler.

Defining the problem

Activist short-selling refers to the practice of taking a short position in a security and then issuing a report or public statement that’s likely to negatively affect the security’s price. If the price declines, the short-seller makes a profit.

In the consultation document released in December, the CSA said activist campaigns range from those that contribute to price discovery through fact-based research and analysis of issuers, to “short-and-distort” campaigns that make false or misleading statements and drive down a stock’s price so the activist can profit from the short position. In between there’s a lot of activity — and a range of ideas on the need for more regulation.

“The issue is that you don’t want to put a chilling effect on the legitimate ability of the market to synthesize public issuer disclosure and provide their analysis and their commentary in appropriate circumstances,” said Ramandeep Grewal, a partner in Stikeman Elliott’s corporate group in Toronto. “There’s always the risk that you would be chilling that kind of required and very necessary commentary that leads to better price efficiency and better operation of the market.”

Activist short-selling isn’t new but has received more attention in recent years, which the CSA said may have to do with social media.

From 2010 to 2020, 73 Canadian issuers were targets of 116 campaigns, the consultation paper said. Activity has increased since 2015 (see Figure 1) but the totals have been inconsistent, which the regulator said indicated cyclical interest in overheated sectors: in 2018, for example, more than one-third of the companies targeted were in the cannabis sector.

Mark Rosen, founder and director of research with Accountability Research Corp., said “numerous weak reports that lacked traction” over the last few years have diminished the impact of short-selling campaigns. Many “offered little new information and were just research reports with a negative slant meant to trigger panic selling,” he said.

The challenge for issuers

Some issuers argue that activist short-sellers can make baseless claims against companies for their own personal financial gain rather than promoting longer-term price accuracy. This hurts not only the companies named but also their shareholders, including retail investors who may respond rashly to the claims and sell while a stock is down.

“When the dust settles — when better information is in the market and calm prevails and the stock returns — the people who are hurt most, ironically, are the retail investors who reacted … a little bit too quickly to the adverse misinformation in the short report,” Singer said.

One of the companies that submitted to the consultation was Calgary-based environmental company Badger Daylighting Inc. On May 12, 2017, Badger became the target of a campaign from California-based short-seller Marc Cohodes. Badger’s shares fell 14% that day as almost five million shares were traded, representing 13% of the outstanding float, the company said. The following week its shares were down by 28%.

“Badger’s management spent significant time and considerable resources to correct the capital market’s understanding about Mr. Cohodes’ unsubstantiated and factually incorrect information,” Badger’s submission to the CSA said.

That information included a Twitter post containing a photo of a Badger truck purporting to support Cohodes’ allegation that Badger was illegally dumping toxic substances.

Badger took the unusual step of announcing in May 2018 that the Alberta Securities Commission (ASC) had concluded an investigation into the allegations with no enforcement action taken.

In August 2018 ASC staff applied for an interim order forcing Cohodes, whose campaign continued, to cease trading in Badger securities and prohibiting him from disseminating misleading or untrue statements about the firm. In a hearing, the ASC rejected the request, dismissing the argument that Cohodes’ campaign had a significant impact on Badger’s stock price. Back on May 12, 2017, the day Cohodes announced his campaign, Badger had also reported its quarterly earnings and missed analyst expectations.

While short-selling is monitored by the Investment Industry Regulatory Organization of Canada, the CSA noted in the consultation document that activist short-sellers aren’t covered under formal regulatory requirements. They are, however, subject to prohibitions under securities law against market manipulation, misleading statements and fraud.

But to fall offside securities regulation, short-sellers’ activity doesn’t only need to be false or misleading — it also must be reasonably expected to significantly affect the market price or value of a security. The ASC case showed that’s a high bar.

Commentary from law firm Bennett Jones following the 2018 ASC decision said that “[e]ven where the statements are false, and perhaps deliberately so, short-sellers may escape regulatory scrutiny if the statements are perceived to be insufficiently authoritative to materially impact, or create an artificial price for, a company’s shares. Of course, while regulatory sanctions may not apply, those who make false statements about companies could well still face civil liability for defamation.”

In the consultation document, the CSA asked whether there needs to be a new standard — one that doesn’t require proof that false or misleading information materially affected a company’s stock price in a negative way. One of Badger’s asks (which echoes CIRI’s submission) is for recourse against activist short-sellers who disclose inaccurate or misleading information.

Ontario’s Capital Markets Modernization Taskforce took up the issue earlier this year. Under the task force’s proposal for dealing with misleading statements about public companies, the OSC would only need to prove intent to mislead and not that the misleading statements actually moved the market. B.C. recently made a similar change to its securities law.

As for the defamation angle, the CSA said that while a statutory provision that makes it easier to seek redress in the civil courts may deter problematic conduct, the liability may unintentionally go beyond activist short-sellers and cover investment analysts.

CIRI’s submission also said activist short-sellers should be required to provide their analysis to issuers before they make it public. This would give their targets an opportunity to respond to the claims.

Xin Zheng, assistant professor at the University of British Columbia’s Sauder School of Business in Vancouver, said such a rule would diminish activists’ beneficial role in markets. “The firms could manage the damage and it’s actually prohibiting the price efficiency in many ways,” he said.

Another proposal involved submitting activist claims to regulators to verify. Zheng said this would likely take too long, though it would be feasible “provided the regulator allows activists to act upon the information right away.”

In their submission for Stikeman Elliott, Singer and Grewal proposed a requirement for short-sellers to report to regulators as well as a “brief mandatory trading moratorium” after the information becomes public. The short-seller could close out their position once the moratorium is lifted, giving the issuer the opportunity to respond.

Grewal compared the proposal to rules prohibiting anyone at public companies that are making acquisitions from trading for a brief period while the market digests the information.

“If the short-seller is legitimate and has discovered credible information about the company, they will still be able to capitalize on it,” she said. However, the brief moratorium would have “a chilling effect” for those putting out information that isn’t legitimate in short-and-distort campaigns.

“It puts pressure on activists to only act in a responsible way,” Singer said. “They won’t be able to immediately take advantage of the initial drop in price that typically follows the issuance of a short report.”

Forensic detectives

Hedge funds and other defenders of activist short-selling say the campaigns are an important check on market exuberance, providing a counter to notoriously positive analyst ratings and sometimes exposing misconduct or fraud. “Activists have the opportunity to discover potential problems with companies’ fundamentals,” Zheng said. More regulation could inhibit that healthy activity.

The Alternative Investment Management Association (AIMA) called activist short-sellers “forensic detectives,” uncovering clues the rest of the market has overlooked.

“Short-sellers play an extremely important role in public markets, not only by providing liquidity and better price formation through their contrarian positioning, but also by performing a policing function that keeps corporations and their management honest,” AIMA’s submission said.

“Often the short-seller is described as the ‘canary in the coal mine,’ providing valuable information to the world about the toxicity of the environment that is hard to spot.”

The most notorious recent case of such righteous sleuthing involved Sino-Forest Inc. In June 2011, hedge fund Muddy Waters released research accusing the TSX-listed timber company of being “a multibillion-dollar Ponzi scheme.” Investigations followed, validating the claims, and Sino-Forest’s stock price plunged to zero. The company’s chief executive was found guilty of fraud and ordered to pay more than US$2.6 billion in damages in a civil case.

Andreas Park, associate professor of finance at the University of Toronto, said activist short-sellers play an important role exposing misleading accounting and fraud. And they also take considerable risk, as it’s expensive to borrow securities to cover a short position.

“You can’t commit capital to that forever. So what are you going to do? You’re going to talk about it,” said Park, a former member of the OSC’s market structure advisory committee.

Making operations more difficult for activist short-sellers could lead to more investors being defrauded by firms, he said.

Social distortion

AIMA is also concerned about more restrictions. Stricter rules against false statements, even when a stock’s price isn’t affected (as Ontario’s task force proposed), would be overreacting “to a perceived problem based on little more than anecdotal evidence,” the association’s submission stated.

But GameStop is a powerful anecdote. In a submission to the CSA, Vancouver-based mining firm NovaGold Resources Inc. acknowledged that while the Reddit traders who pushed up GameStop’s stock “would be better defined as activist long-sellers, the effects of the use of social media, the lack of accuracy or logic behind the investment thesis, manipulative intent to distort prices, and the noticeable and documented disruption in the market and on market participants are similar.”

Another Vancouver mining firm, Northern Dynasty Minerals Ltd., said it had been targeted by organized traders who pump up the stock on social media before switching to a short position; they then go negative on social media to drive the price down and profit from their position, according to the company’s submission.

The CSA acknowledged the challenge in the consultation paper: “[T]hrough social media platforms, prominent activists with a large following can promote and disseminate their short theses about target companies to a broader audience and at a much faster pace.”

Grewal compared the speed at which misinformation can spread online to the obstacles issuers face before responding. Companies have to investigate an activist short-seller’s information and document the process before coming out with a public market disclosure, she said.

“Companies can’t immediately respond,” she said. “And as we know in this day and age, with social media and everything else, if you can’t immediately respond you significantly risk missing your window. The share price will likely be impacted.”

Issuers then have to decide whether it’s worth responding after the damage is done. “Attention spans are short,” Grewal said. “Once the market and the media are no longer talking about you, do you really want to come back and remind them that you had this short-seller report?”

This kind of decision may become more common for issuers. Law firm Norton Rose Fulbright Canada LLP said increased online trading and social media use could lead to more activist campaigns. “The rise in the use of social media and an increase in trading, especially by retail investors and other investors who rely on social media when making decisions to trade in securities, may provide fertile grounds for increased activity,” the firm stated in its submission.

That means more work for advisors. Rosen said retail investors “trading poor quality information on message boards” could lead to more overreactions to short reports.

“These overreactions have increased volatility and risks for advisors,” he said.

How should advisors respond to activist short-selling campaigns?

Advisors should treat activist campaigns as they would any unexpected information about a company, said Mark Rosen, founder and director of research at Accountability Research Corp. That means taking in all the information, considering its validity and making a judgment call.

“If a report doesn’t identify a clear imminent catalyst, or provide material and quantifiable new information, then advisors have plenty of time to assess the situation,” he said.

Advisors should read the full short report, watching for a lack of balance or for information that’s being omitted or skewed, Rosen said. They should then review the company’s response, which should be “measured, thorough and credible.”

“If the company is straining to respond, it might be time to sell,” he said.

In addition to the obvious risks, activist campaigns can also present an opportunity: a stock may become oversold from “knee-jerk selling,” Rosen said.

Andreas Park, associate professor of finance at the University of Toronto, said “capital is cruel” when it comes to investment choices. “Maybe a firm has been tainted by an activist short-seller, but that means that for other investors there’s an opportunity to make money off that,” he said.

Advisors should try to respond to a campaign that exposes damaging information as though they weren’t responsible for the initial decision to purchase the security, Rosen said. “They shouldn’t let investor psychology stop them from selling at a loss.”

Figure 1: Activist short-seller campaign activity in Canada

*to September 2020. Source: CSA Consultation Paper 25-403, Activist Short Selling, based data from Activist Insight