The recent attack on the Adani Group by Hindenburg Research has made it clear that short-selling activism and short-seller reports have gained real traction in India. The use of short-seller reports is a real headache for companies under attack. Amid this recent development with the Adani Group, many companies are trying to figure out how to respond to it, proactively as well as after the fact.
1. Short-seller activism explained
Short-selling is an investment strategy wherein the short-seller identifies overvalued companies, borrows securities of the company, and sells them at the current market price. The short-seller plans to buy back these securities at a lower price in the future, thus profiting from a decline in the companies’ stock prices. The securities are then returned to the lender and the short-seller pockets the price difference between the purchase price and the selling price as a profit.
Activist short sellers are typically hedge funds or individuals who actively try to drive down the stock price after taking short positions in a company’s stock. This is done by publishing a research report which claims that the target firm is overvalued. Regulatory risks, accounting issues, undisclosed information, odd related-party transactions, mysterious foreign subsidiaries, and other similar problems are typical “findings” that are pointed out in these research reports. The modus operandi also includes spreading the content of the report on various platforms, such as Twitter, and in mainstream media in order to give it maximum spread and effect.
2. The regulatory framework
Manipulative and deceptive practices are defined under Chapter V, Section 12A, of Securities and Exchange Board of India Act, 1992. SEBI has also implemented preventative measures with respect to market manipulation and price rigging. SEBI, in collaboration with the exchanges, may seek clarification from the company regarding short-seller reports, and can also temporarily suspend trading for reasons of suspected or alleged market manipulation or price rigging.
Disseminating information which gives, or is likely to give, false or misleading signals as to the price of a financial instrument generally constitutes market manipulation. Dissemination of rumors, where the person who made the dissemination knew, or ought to have known, that the information was false or misleading, would also constitute market manipulation.
It is also important to discuss here whether or not short-seller reports constitute “investment recommendations”. If a short-seller report is considered to be an “investment recommendation,” other compliance requirements also become applicable for the short-seller.
The determination of whether a short-seller report should be seen as an “investment recommendation” and whether the publication of an activist short-seller report constitutes market manipulation is ultimately for SEBI and the courts to decide.
3. Dealing with short-selling activism
Despite the growing importance of activist short sellers, little is known about how firms respond to these reports. Once short-sellers are active in a company’s stock, investor relations professionals need to decide quickly how to deal with the attack. The decision to engage or ignore shorts will vary from management to management and company to company. Here we discuss various strategies and tactics that companies can use to fight off the short-sellers.
3.1 Silent treatment
Companies are not obligated to respond to short-seller reports. In some cases, not providing a response is the best response. This is especially true if the company is confident that its projections are accurate, that it will meet expectations, and it has been forthcoming with investors in the past.
In a study of corporate responses to 351 short-reports published on US-listed companies between 1996 to 2018, it was determined that companies have responded to just under one-third of activist short-sellers in the past – the rest giving the silent treatment.
A company cannot respond to every little criticism. This is especially true if the attack is on message boards, chat rooms and social media. If the company is being shorted because of a pessimistic outlook about the market or industry, or because of a possibility of a downturn in the company’s situation, there is little a company can do except provide reasonable assurance to investors.
But in the event of a bear attack, a significant impact on stock prices, or damage to a company’s reputation, the company is well advised to launch aggressive strategies and tactics to respond.
3.2 Responding to allegations
The best possible response is for the company to put out an analysis addressing the allegations. The company needs to provide a swift, well-thought response that clearly recognizes the allegations as incorrect while citing the company’s relevant disclosures and compliance. Such a response can make the problem disappear overnight and can avoid permanent damage to the company’s reputation.
Companies should take the example of corporate behemoth General Electric and how it dealt with a short-seller report. In 2019, when GE was attacked by Harry Markopolos, the company did everything right. They put out their own analysis of the allegation and it went away pretty much overnight. The key was that GE didn’t attack the short-seller apart from pointing out that the analysis was wrong.
3.3 Conducting an internal investigation
One of the worst possible responses is launching an internal investigation in response to a short-sellers’ allegations. This is true particularly if the investigation is launched by the board of directors.
Initiating an internal investigation implies that the firm’s directors are not confident in management to trust existing disclosures and management representations, and it is a significant negative signal. Announcements of internal investigations are strongly associated with enforcement actions, lower acquisitions in the future, and a higher rate of being delisted.
When credible allegations of fraud and misconduct are presented, the firm’s directors have a fiduciary duty to investigate to protect the firm and its shareholders by maintaining oversight of the firms’ compliance with laws and regulations. Firms generally launch internal investigations when the firm’s directors either have significant uncertainty about whether or not fraud has taken place or suspect that fraud has occurred, and the purpose of the investigation is to limit liability and penalties.
Directors exercising their fiduciary duty to investigate allegations of fraud and malfeasance by launching an internal investigation are advised to do so by engaging outside legal counsel. The purpose of internal investigations is both to evaluate risk exposure and mitigate legal liability and potential penalties through cooperation with authorities. A key benefit of utilizing outside counsel is to protect the investigation’s findings with attorney-client privilege, allowing the firm to avoid having to disclose any resulting findings either to shareholders or to authorities unless the firm elects to waive this privilege. The internal investigation then affords the firm an option to either maintain confidentiality or to waive privilege and provide the results to interested parties such as shareholders or the authorities.
3.4 Legal action
Short-sellers can be sued for libel and defamation by the target firms. Successful defamation claims require the target firm to prove four elements:
- that the short seller made a false statement purporting to be fact,
- communicated that false statement to a third party,
- that the false statement was negligent or malicious,
- and that the target firm suffered damages as a result.
Companies can sue short sellers for defamation even when the report is accurate, as a bluffing strategy to try and force the short seller to withdraw the report rather than incur the legal costs of defending the action. Companies are well-advised to remember that this is a bluffing strategy which will not work against hedge funds with deep pockets, nor will it stand up in court.
Short sellers have successfully defended themselves against defamation lawsuits by demonstrating that their analysis was either accurate or an expression of opinion rather than fact. Andrew Left (StockLemon, later renamed Citron Research) successfully mounted a defense against GTX Global Corp when GTX sued Left for criticizing the company on his website. Andrew Left published a website called StockLemon where he made comments that were critical of GTX Global Corp, and GTX sued, claiming that Left made defamatory statements about the company. In May 2007, the California Court of Appeals held that Left’s criticism of GTX was an exercise of free speech, and GTX, in their complaint, had failed to meet the heightened evidentiary requirement for a claim of trade libel, defamation, and securities fraud.
3.5 Acquire a strong business
Short-seller reports frequently question the valuation of their target companies, among other concerns. Acquiring a strong business or even royalty interests can provide a significant boost to earnings and cash flows, thereby alleviating the overvaluation concerns.
When Alaris Royalty was the target of short-selling by Broadview Capital in 2015, Alaris provided $30 million in financing to Providence Industries in exchange for ongoing royalties. The stock shot up 32%, causing some serious pain for the short-sellers.
3.6 Dutch action or open market buyback
In such a buyback, the firm specifies a price range within which shares are repurchased from existing shareholders. Conducting such a buyback would put an end to short-seller concerns. In addition to cancelling a large amount of shares at once, which makes it harder to short, the move also emphasizes the company’s strong balance sheet and cash flow.
Home Capital was a target of a very aggressive short sell attack in 2015. The company did have some mortgage fraud issues, but the company had dealt with the problem and the amount involved was relatively small. A $150 million Dutch action buyback of 3.9 million shares drove up the stock price 42% as the shorts headed for cover.
3.7 Pay a large special dividend
When you short a stock, you are selling a stock you do not own. If a dividend is paid on the stock, it is the short-seller’s responsibility to cover the dividend. This can be an ongoing cost to short sellers in addition to borrowing costs. Short-sellers really do not like paying dividends to someone else. So, when the company pays a huge special dividend, it becomes extra painful to short sellers.
3.8 Solid earnings
As noted above, short-sellers typically question the valuation of their target companies. The best way to justify those valuations and emphasize the company’s strength is by reporting blockbuster numbers. Nothing makes short sellers squirm more than solid operating performance.
4. Mistakes to avoid when dealing with short-sellers
Here are some mistakes companies need to avoid when fighting off activist short-sellers.
4.1 Never engage the fight in the media
Dealing with short-sellers is about keeping the market informed and maintaining credibility. It is never about engaging. Companies should address the allegations or respond to the report through a media statement or press release. Never engage the fight in the media. No company has ever won the perception battle by fighting it out in the media.
4.2 Don’t discourage shareholders from lending
Some companies try to persuade shareholders to remove their shares from margin accounts, or discourage lending of shares. This strategy is generally ineffective and is a waste of time. It also shifts focus from the main issue, i.e. the negative factors identified in the report which are (allegedly) not reflected in the stock’s valuation.
4.3 Neglecting employees is a mistake
While companies need to focus on dealing with short-sellers, it is a mistake to neglect the internal audience, i.e. employees, especially when many employees hold company stock. Employees get nervous when they see wide swings in share prices for no apparent reason. Companies need to be in communication with their employees, keeping them informed about the developments, and assuring them why your company remains a great place to work.
4.4 Coordinated and comprehensive response is needed
Abusive short-sellers can severely damage a company’s reputation and do it quickly. A company must take a coordinated and comprehensive legal, crisis management, public relations, investor relations, and financial approach. Anything less is temporarily palliative, at best. It is recommended that the company seek support and advice from experienced legal counsels, strategy and finance consultants, and crisis management experts. Having these teams in place, either in-house or as external consultants, will ensure the company can respond quickly and accurately. That way, the management can concentrate on what it does best, which is run the business and manage the crisis on a strategic level.
Although not advisable, if the management is planning to directly engage with the short-sellers, they should be prepared to devote a good deal of time, including senior management’s time, to handle the situation.
5. Preventative measures
While it is possible to effectively fight back short-sellers, implementing good corporate governance and avoiding such attacks is still the best remedy. Here are a few measures companies can take to discourage activist short-sellers.
5.1 Adequate disclosures and strong internal controls
Short-sellers are most successful when they can create the appearance that there is material information that is not properly disclosed and thus reflected in the company’s valuation. The best defense to avoid being targeted by short-sellers is to have adequate internal controls in place to detect and correct any operational, financial, or disclosure-related issues that short-sellers are generally inclined to exploit. Informative and forthcoming disclosure, not just in earnings conference calls, but in quarterly and annual reports, is sufficient to discourage most short-sellers.
5.2 Clear communication policy
It is important to have a clear communication policy that not only complies with applicable rules and regulations, but also includes the names of the responsible spokesperson(s), as well as guidelines for internal as well as external communication. Having a clear communication policy also enables the company to make better decisions and respond swiftly in case of an attack by a short-seller report.
5.3 Performance
Of course, nothing beats performance. Deliver earnings and revenues that meet or beat expectations, provide clear guidance regarding future outlook, disclose any unforeseen events appropriately, follow through on what you say you’re going to do, and keep the market informed of progress against objectives.
6. Conclusion
A number of strategies and tactics are discussed above that companies can use while dealing with short-sellers. Addressing the allegations is the best response, although many companies choose to deny the allegations or not respond at all. An internal investigation is the worst possible response, unless directors are exercising their fiduciary responsibility. Legal action (if allegations are incorrect), making a strong acquisition, doing a buyback, or paying a large special dividend, are aggressive tactics that can cause serious pain for short-sellers, but are also extremely expensive to execute.
Companies are also advised not to engage the fight in the media, to ensure employees are informed of the developments, and to have experienced advisors in place to deal with such an attack.
Earnings and revenues that meet or beat expectations, clear guidance regarding future outlook, strong internal controls, appropriate disclosures, and keeping the market informed of progress against objectives, are the best preventative remedy against such attacks.
That said, no strategy or tactic will help if your fundamental business itself is awry. Business problems must be addressed first. If the allegations are not correct, then it’s easy to respond. But if the allegations are correct, then the company clearly has a different problem, especially when the accusations revolve around fake assets, revenues, and mysterious foreign subsidiaries.