Here come the activist short sellers

The impending attack on a locally listed target by Glaucus will spur debate about the limits of negative research.

Soren Aandahl, the director of US activist short seller Glaucus Research. (Colin Murty/The Australian)

A dormant debate about the virtues of short selling is about to be rekindled with the imminent entry to this market of one of the new breed of “activist” short-sellers.

As The Australian’s Paul Garvey revealed last week, a US short seller, Glaucus Research, is only weeks away from publishing its first research on Australian companies.

The analysis will, of course, be negative and published after Glaucus has taken up a short position in the stocks.

The distinguishing aspect of activist short sellers is that they publish and distribute widely their research on the stocks they have targeted, seeking the maximum effect.

While that makes them more visible than those who short stocks without being identified, which provides a focus for debate and charges of market manipulation, it also means their actions are more transparent and they themselves are more vulnerable.

The most common accusation against activist short sellers like Glaucus is that they are engaging in market manipulation. Their defence is that their approach is simply the mirror image of buy-side analysts and investors. Instead of researching stocks that they believe will rise they look for shares they believe are overvalued and which will fall once the market is made aware of that.

Glaucus’ approach is particularly interesting. Co-founder Soren Aandahl, a Harvard-educated former corporate lawyer, interned at the Californian US Attorney’s office on a taskforce set up to prosecute Enron executives after the former high-flying company’s collapse amid revelations of accounting fraud.

Aandahl subsequently worked at a major New York law firm, Kirkland & Ellis, where he was involved in “reverse mergers” — what we’d call backdoor listings — of Chinese companies seeking listings in the US. That gave him an insight into Chinese companies and their accounting practices.

Glaucus’ primary approach, formed from those experiences, is to focus on companies where it believes there has been accounting fraud or misstatements. While there are other short sellers with a similar style, that makes it different to the conventional value-based trader.

The firm has been particularly active in Asia, where it has generated controversy and aggressive responses from companies, investors and regulators.

When it entered Japan, publishing research critical of the accounting practices of Itochu, a major Japanese trading house, the head of the Tokyo Stock Exchange questioned the ethics of taking up a short position before releasing negative research.

In Taiwan, the corporate regulator launched a criminal investigation into Glaucus after it took up a position and issued an analysis of Asia Plastic Recycling that alleged its actual financial numbers were 90 per cent lower than those it was reporting.

In Hong Kong, the activities of Glaucus and its fellow activists have caused something of a regulatory backlash, with the authorities toughening up disclosure requirements and restrictions on the companies where short selling is permitted and threatening action against reports they consider misleading.

Glaucus’ track record says that it holds its short positions for quite lengthy periods after publishing its research — it doesn’t take advantage of the usual instant fall in the share prices of its targets to close out the position. That means its analyses can be properly tested and debated and reduces the prospect of it being accused of market manipulation.

There are risks to its approach. In the US and Australia market manipulation is an offence, as is the publishing of false or misleading statements. Activist short sellers in the US have faced a myriad of law suits from companies and investors on those grounds. There is an obvious risk of class actions if the firms get their analysis wrong and damage a company and its share price in the process.

The transparency within the approach, however, holds the potential for a more efficient and more accountable marketplace. If it’s good enough for the “buy-side” of the market to publish bullish reports it ought to be regarded as a positive if there are those casting a spotlight on flaws in accounts and business models.

It was a group of short sellers targeting UK professional services firm Quindell, questioning its accounts, its business model and its valuation that helped trigger its eventual collapse, not long after Slater an Gordon made its disastrous decision to buy the bulk of its business.

In this market, Glaucus has identified two companies as targets and plans to
“go public” with its opinions on one of them within weeks.

Given that it targets companies with market capitalisations of between about $500 million and $3 billion — it needs companies where it has the ability to borrow significant volumes of shares — it appears reasonable to assume the initial objects of its attention are going to be big enough to generate attention and trigger a new bout of debate about the merits and ethics of short sellers and activist short sellers in particular.