What happens when a short seller takes active steps to negatively impact the price of a security and profits as a result? The answer, unfortunately, is often unsatisfactory for investors and advisors.
There is a growing trend in Canada of U.S.-style short sellers releasing negative research publications that target Canadian and dual-listed issuers. For instance, the 2011 Muddy Waters Research LLC research report targeted Sino-Forest Corporation, which arguably contributed to the demise of the company. There have been numerous examples since then, including short-seller reports about Valeant Pharmaceuticals, Home Capital Group and Nobilis Health Corporation.
Negative research reports can be difficult to categorically disprove and, as a result, they often lead to a significant drop in the target company’s share price, enabling the short seller to profit.
Apart from the immediate impact of a precipitous share price decline, these reports can also cause reputational damage, and often trigger costly internal and external investigations and securities class actions—the costs for which are typically borne by the remaining shareholders or the company’s insurers.
Unfortunately, it’s not always easy for companies to set the record straight after a short-seller report is released. The first step taken by many companies is an effort to salvage their reputation by carefully scrutinizing the report for any inaccuracies, misleading information or defamatory content. Certain companies have had success rebutting short-seller allegations by counter-distributing press releases and reports by independent director committees or external advisors. Recently, Callidus Capital successfully combined such countermeasures with a share buy-back campaign, which helped drive the share price back up. Still, in many instances, regardless of what the target company may say or do, the legal, reputational and financial damage is done and the short seller has profited from the decline (short-term or otherwise) in the company’s stock price.
Canadian regulators have taken measures to regulate short selling, including changes to IIROC’s Universal Market Integrity Rules, which require market participants to identify any trade that qualifies as a short sale at the time of order entry. This allows regulators to produce reports on the proportion of short sales in the total trading activity of an issuer’s securities.
However, there’s no requirement that a short seller’s identity and overall short position be publicly disclosed. As such, while the investing public and their advisors have access to information relating to the total short position in an issuer, they don’t know who the short sellers are, or the size of their respective positions.
In addition, the country’s securities regulators rarely pursue enforcement proceedings against short sellers, and attempts to do so have not been met with success. For example, a May 2015 BCSC decision dismissed allegations of wrongdoing and breach of public interest made against Jon Carnes, a short seller and the publisher of a negative research report about Silvercorp Metals Inc., a TSX-listed company with several mining assets in China.
In September 2011, Silvercorp’s shares fell 30% in one day after Carnes (using a pseudonym) published a negative research report alleging that certain information uncovered regarding Silvercorp’s projects suggested varied reporting, inconsistent reserve numbers and numerous challenges. The following day, Carnes earned a profit of US$2.8 million when he closed his short position.
BCSC staff alleged that Carnes committed fraud contrary to the B.C. Securities Act by knowingly misrepresenting and omitting important facts regarding the conclusions of a geological consultant in order to cause the company’s share price to drop.
Although the hearing panel agreed that “Carnes intended to write the most damaging report he could, to make the most money possible, and was prepared to write things in a way that connoted or implied things that were not explicitly said,” it concluded there was insufficient evidence to prove fraud. The BCSC found Carnes’ conduct “unsavoury,” but not clearly abusive to the capital markets. As a result, the allegations against Carnes were dismissed. This result was an unwelcome precedent from the perspective of target companies and their investors, and a potential disincentive for regulators to pursue future cases.
Given the lack of regulatory oversight of short sellers who profit from their own damaging reports, advisors should help clients avoid the impact of such actions where possible. In addition to avoiding concentration in any one issuer, advisors should also consider factors that may make a company an attractive target to short sellers.
Although this kind of short selling is impossible to predict with certainty, past examples show that short sellers are more likely to target companies with large debt, uncertain strategy, or frequent acquisitions. And, they are more likely to avoid companies with high insider ownership, no or low debt, and those that pay dividends (which make shorting more expensive). Further, trade reports maintained by regulators, such as IIROC’s monthly short sale trading statistics summaries, may provide useful information regarding the overall short positions in the company.
In summary, investors who take a long view of their investment strategy are likely better positioned to weather the storm that can be caused by the publication of an unjustified negative short-seller report.
by Wendy Berman and Lara Jackson, partners in the securities litigation group of Cassels Brock & Blackwell LLP.