Groundless Complaints

The Louder the Complaints against Short Sellers, the More Investors Should be Concerned

When a company’s share price falls, senior management may blame short sellers for the decline and allege illegal trading activities.

Short selling allows one to communicate less optimistic expectations to others. “Firms don’t like it when someone shorts their stock, and some firms try to impede short selling using legal threats, investigations, lawsuits, and various technical actions,” said Yale university Finance Professor Owen A. Lamont in June 28, 2006 testimony before the Senate Judiciary committee. (35)

“Consistent with the hypothesis that short sale constraints allow stocks to be overpriced, firms taking these anti-shorting actions have in the subsequent year experienced very low abnormal returns of about 24 percent per year. The negative returns continue for up to three years. What appears to be happening is that these companies are overpriced, either because of excessively optimistic investor expectations, faulty products or business plans, or just plain fraud on the part of management.”

Lamont looked at long-term returns for 270 firms who threatened, took action against, or accused short sellers of illegal activity or false statements.(36) “The evidence is strongly consistent with the idea that short sale constraints allow very substantial overpricing, and that this overpricing gets corrected only slowly over many months,” he told the senate panel.

“Aggregate short selling tends to increase in bear markets, which perhaps makes it all the easier for people to blame the messenger,” according to a paper by Lamont and Harvard Professor Jeremy C. Stein. They see the problem as “not too much short selling in falling markets” (volume of short interest is very small compared to total share volume) but rather as too “little in rising markets.” In their view, “any regulatory efforts to constrain short selling are likely to be misguided.” (37)

In 2001, Enron, once the seventh largest US company, collapsed into bankruptcy. About one year before its demise, some investors began shorting the stock after determining that the company was using accounting methods to overstate earnings. Cryptic financial disclosures were additional alarms. Short sellers’ independent research and resolve allowed them to position their clients to avert losses that other investors suffered by holding the stock too long.

The traditional watchdogs failed in their job of protecting investors in Enron. as an exhaustive staff report of the senate governmental affairs committee found, “Despite the magnitude of Enron’s implosion and the apparent pervasiveness of its fraudulent conduct, virtually no one in the multilayered system of controls devised to protect the public detected Enron’s problems, or if they did, they did nothing to correct them or alert investors.”(38)

Other examples of short sellers’ prescience include Adelphia, Boston Chicken, Baldwin United, Conseco, Global Crossing, Sunbeam Corporation, Tyco, and Worldcom. These were companies whose fundamentals were scrutinized by professional investors and found to be inadequate to support their market valuation and management’s pronouncements.

Britain’s Regulator Drops Investigation in 2008

On March 19, 2008, shares of the Halifax Bank of Scotland (HBOS) — a banking and insurance group that is the largest mortgage lender in the United Kingdom — fell 17 percent. That sudden drop prompted the U.K. Financial Services Authority (FSA) to investigate charges of potential trading-regulation violations by short sellers.

By August 2008, the FSA had dropped its investigation, concluding that no action could be brought despite a wide-ranging probe examining thousands of emails and telephone records.(39) The FSA said it “has not uncovered evidence that [false rumors] were spread as part of a concerted attempt by individuals to profit by manipulating the share price.” The FSA’s investigation included 40 staff reviewing transactions in HBOs shares in search of suspect trades, and also scrutinizing communications including internet message boards.