Tuesday 12 November 2019 6:51 am

The rising abuse of short-selling tactics could have severe consequences on healthy businesses

Ben Hamilton is managing director at Kroll, a division of Duff & Phelps.

Share prices have always been subject to manipulation. The “pump and dump” phenomenon in penny shares has been such a common risk that many people avoid buying such volatile stocks to this day.

Layers of legislation and regulation have been designed and policed to prevent companies and brokers from this kind of activity — broadly with success in the more liquid, highly capitalised company stocks that make up the FTSE 100, S&P 500, and similar indices.

However, in recent years, we have seen a rise in manipulation against these larger stocks, connected with short-selling. Unfortunately, it seems that the regulations and enforcement activities have yet to catch up with this phenomenon, which is largely going unchallenged, damaging healthy businesses and honest management teams, sometimes terminally, to the detriment of investors.

Short-selling — betting that a stock price will fall — is a perfectly legitimate activity when done honestly. Indeed, there have been some notable examples where short-sellers have identified structural flaws in companies, and prompted market corrections in their price. 

In some instances, frauds or poor accounting practices have been discovered by the shorting activity of thoughtful investors. In these cases, the shorters have scrutinised information available to everybody and seen through exaggerated company claims. 

But there is a dark side to short-selling too. We are seeing an increasing number of cases where unscrupulous traders have deliberately spread false but plausible rumours, having already taken short positions — a practice known as “short and distort”. When the rumours prompt stock price falls, the traders are able to close their positions, sometimes within hours, and make considerable profits.

A simple example of this, which was successfully prosecuted in the US, concerns Emulex, a computer hardware business. In 2000, a hoax press release was released on a newswire by a student who falsely stated that Emulex’s chief executive had resigned and that the previous quarter had delivered a loss rather than a profit. Emulex stock fell by 60 per cent in just 15 minutes, allowing the student to make over $240,000 from short trades.

These activities are becoming increasingly sophisticated. In the cases we have investigated, it is not the holder of the short position who spreads the rumour — they pay or incentivise someone else to do so on their behalf. That person often does the research but disseminates it anonymously. By distancing the monkey from the organ grinder, the conspiracy is harder to detect.

Another element can be the spoofing of order books on exchanges — for example placing very large offers to sell a stock at a low price, and then cancelling them before it needs to be fulfilled. This is done to trigger trading algorithms used by some large funds, which are tricked into believing that the price of the stock is falling, and sell their own stock to avoid losses. 

It is possible that the broker who does this for the fund taking the short position may be getting a return by investing in the fund itself, rather than receiving payment. Often, it may be difficult to trace the nature of collaboration between the two parties.

There are clearly a number of significant challenges for regulators in policing this kind of crime. 

First, shorting positions can be taken in a large number of different markets, not all of which are visible to a single regulator, and some of which are much more private, such as spread betting firms. Second, there are differences in the laws on insider trading between the UK and the US, which may also be being exploited. And then, of course, there are issues around funding and skills of regulatory bodies.

But this is no excuse for not acting.

The abuse of electronic trading and internet anonymity could have severe consequences for healthy businesses and their investors if these trends are left unchecked. 

It may only be a matter of time before such malevolent activity becomes part of mergers and acquisitions activity too, by driving down the price of a company so that its shares are cheaper to buy. 

New legislation and further transparency is needed before all of these types of illicit profiteering are checked. We need to press for this to happen before confidence in the stock market is dented. 

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