Companies in the crosshairs

The boards of listed companies must now deal with potentially chaotic new elements in shareholder relations.

Seek chair Graham Goldsmith AO FAICD was working from home during a lockdown in October last year when he received emails from investment bankers forwarding a report on the jobs and education platform by US investment fund Blue Orca Capital. The report alleged that Seek’s business in China, Zhaopin, was full of junk employment listings to maintain the illusion of user growth, thus inflating its valuation — and had inflated its profits with questionable non-cash gains and aggressive accounting.

Blue Orca, a US short seller, was trying to drive down the Seek share price so it could profit from the fall. It worked, at least initially. The Seek share price plunged as much as 10 per cent before trade in the asset on the ASX was halted while the company marshalled its resources and formulated its response. Seek had just become the latest Australian company hit by an activist short seller. “It absolutely came out of the blue,” says Goldsmith of the report.

How it works

Short sellers profit by borrowing an asset from another investor, selling it and buying it back at a lower price. For instance, a short seller might borrow shares from a super fund and sell them at $1 each. If the share price then falls to 80c, it can buy the asset back, return it to the super fund and keep the 20c difference.

Many note short selling has a role to play in driving market efficiency, liquidity and outing fraud. In a recent UNSW BusinessThink article, economist Richard Holden says short selling improves market efficiency so much it could have prevented the 2008 GFC. “Had there been an easy way to short the housing market earlier, the bubble might never have gotten out of control,” he says. “Short selling punishes speculation by putting a check on out-of-control markets. It motivates investors to keep an eye on fundamentals, not just get carried away with what John Maynard Keynes labelled ‘animal spirits’ — the impulses that help drive speculative bubbles and busts.”

There have been recent high-profile cases overseas of successful short campaigns contributing to the uncovering of malpractice, including alleged fraud at German payments company Wirecard and alleged pyramid selling at music streaming company Akazoo in 2020.

In June, ASIC released new guidance on activist short-selling campaigns in Australia. “Activist short selling involves a person taking a short position in a financial product and then publicly disseminating information (one or more reports) directly or through an agent to negatively impact the price of the product (‘short report’),” the regulator says. For example, the short report may criticise an entity’s finances, management, public disclosures or future prospects. ASIC notes short-selling campaigns target entities with “complex and opaque corporate structures and accounting practices, or poor disclosure”. However, ASIC says, activist short sellers can also unduly distort the price of a target entity’s securities by “making false or misleading statements, providing an incomplete view of the facts, drawing conclusions unsupported by adequate evidence, or by using overly emotive or inflammatory language to distort the facts — ‘short and distort’ campaigns”.

Risk factor

Short selling does come with the risk the price will go up. Unlike long- investors, whose losses are limited by a floor at a zero share price, short sellers face potentially unlimited exposure. The potential scale of the losses short sellers face hit the headlines earlier this year when an attempt by hedge funds to short US video game retailer GameStop backfired after retail investors bought shares in huge numbers, driving the price up 1700 per cent and resulting in a short-squeeze — where, the “shorters” increase the share price when they try to buy assets to return it to its owners. The incident also underlined the increasing influence of retail investors on share markets.

About 20 companies have been targeted by activist short sellers in Australia over the past decade, according to ASIC. In North America, by contrast, the number is 1200, with 300 in Asia and about 100 in the EU. In Australia, companies including Treasury Wine Estates and WiseTech have been targeted. Both declined interviews.

The Seek saga

At Seek, Goldsmith rapidly convened a board meeting for later that day and while the directors believed they needed to respond to the Blue Orca report, they decided against responding in point-by-point detail to each claim. “If you take that approach, there’s a risk that’s seen as giving the report more credibility than it deserves,” says Goldsmith.

Instead, it responded in two buckets — on the China business and the accounting treatment. The accounting treatments had previously been fully disclosed to the market and for China, Seek pointed to all the cash and dividends it was generating as proof it was profitable. Its response was lodged on Monday morning ahead of the market reopening, prompting Blue Orca to release another two-page report within the hour, which the company didn’t respond to because they felt it lacked credibility. In fact, the hedge fund had missed a line item of cash in the China accounts, which some sell-side analysts pointed out in reports later that day.

“The share price didn’t look back from there. It’s a matter of staying calm, gathering your resources and being thoughtful in how you respond,” says Goldsmith, who is concerned there is no transparency about who holds shorts in a company in the way there is for substantial shareholders, meaning short sellers have the element of surprise. He’d like to see funds required to declare any short positions above one per cent of the company asset so these attacks don’t come totally out of the blue.In Australia, generally no more than 15% of a company's shares are shorted.

While companies may not be able to prevent short-selling attacks, they can be prepared for them. “Understand where someone’s going to attack you and make sure you don’t have anything to hide — you’re open and transparent,” says Goldsmith.

ASIC position

ASIC believes short selling has a legitimate function in the market — to boost liquidity and help with price formation. Equally, says Calissa Aldridge, ASIC senior executive leader of market supervision, the practice can be abused and leave investors and companies believing it has unfairly affected share prices. “Our focus is absolutely on maintaining the integrity of the market, ensuring that misinformation is dealt with quickly,” says Aldridge.But she notes Australia’s long tail of listed companies and warns that the fact relatively few have been sold short by activists means they might increasingly be a target. “Some of the governance, controls and expertise in the [small to mid-range] companies around the way they manage their accounts, they have less resources to focus on those things so are potentially more susceptible to issues.”

Balanced against that are Australia’s generally high standards of governance and the market’s continuous disclosure regime, which means some of the issues short sellers would seek to exploit are coming to the attention of the broader market earlier than in other jurisdictions.

Aldridge’s colleague Tom Veidners, senior manager equity markets surveillance, says companies with complicated accounting treatments or hard-to-understand business models or acquisitions are most likely to come under the scrutiny of short sellers. “We’re seeing an increasing trend where activist shorts are spending a lot of time looking at complex accounting treatments and roll-up acquisitions.” He says target companies that have provided detailed responses to short sellers’ reports have often seen their share prices recover quickly. Aldridge says more transparency around business models and accounting treatments would help companies avoid being targeted in the. ASIC has a focus on activists short selling, but isn’t opposed to it, because “in many cases it does bring to light additional information or consolidates existing information and you end up with, on a net basis, more information or better information in the market”, he says. “But we’re also acutely aware of instances where it seems the activist shorts have been releasing misinformation or overstating facts — and that can impact share prices.”

ASIC’s new guidance for short sellers advises them to release their reports outside of market hours and engage with target companies to ensure they don’t release misinformation or disinformation. But Aldridge acknowledges part of the short seller strategy is to release information during trading hours to take companies by surprise for maximum effect; and many are based offshore and “may be less inclined to follow the guidance”.

ASIC is also working with the ASX to reduce the time it takes for a company to get a trading halt in place — potentially for the ASX to use its powers to pause trading pending a decision on a trading halt from a company — and thus reduce the amount of time the shares are trading in an uninformed market. The regulator’s view is that companies need to respond to a short seller’s report in order to meet their listing obligations to ensure there is an informed market in their shares. They should address each of the claims in the report, but not immediately be defensive. “In many cases, the activist short reports are actually shining light on a particular problem and so company directors should carefully consider and investigate the assertions,” says Aldridge.

ASIC monitors trading around activist short selling reports and might identify market manipulation if, for example, a short seller closes out their short position before a company has had a chance to respond. ASIC has limited regulatory oversight of offshore activist short sellers, which are not required to be registered in Australia, but is increasingly working with offshore counterparts to focus on these practices. The regulator has not so far launched any actions against activist short sellers.

One board responds

The first managing director David Bryant knew about a short-selling attack on real estate investment trust Rural Funds Management was when the ASX rang to advise the asset price had plummetted and to see if they wanted their shares placed in a trading pause. “It was completely out of the blue,” says Bryant, about the release of a report by Texas-based Bonitas Research, which stated Rural Funds was a fraud and its shares completely worthless. The share price plunged 42 per cent in half an hour, wiping hundreds of millions of dollars from market capitalisation.

The board decided to halt trading in the company’s shares for the two days allowed by the ASX while it considered its response. It commissioned an independent report into its accounts by EY rather than its own auditors, PwC, because the audited reports were being called into question. “We had every confidence in our accounts and knew that they would stand the scrutiny of an independent expert,” says Bryant.

The next question for the board was whether to recommence trade in the shares after two days or request a longer suspension while the independent investigation took place. Confident that the accounts would be vindicated, it announced the investigation and recommenced trading. “We left it to the independent expert to investigate our accounts rather than engaging in tit-for-tat responses, which is too arduous, says Bryant. “You’re lowering yourself to their level, but it’s not a level battlefield.”

Domiciled in foreign jurisdictions, short sellers can essentially say anything they wish, whereas any announcement by an ASX- listed company is carefully scrutinised by regulators. “You’re fighting with two hands tied behind your back,” says Bryant, who agrees short selling has a place in expressing investors’ different opinions about a stock, but describes short sellers who produce spurious reports as “conspirators — they conspire to defraud shareholders of the value stored in the shares they own”.

Rural Funds took Bonitas to court, alleging malicious and deceptive conduct. Bonitas didn’t defend the proceedings, saying Australian courts had no jurisdiction over it. In February 2020, the court found Bonitas had contravened the Australian Corporations Act 2001 and the ASIC Act 2001. It said the statements made were false and misleading and “they did not care that they were false”.

Rural Funds was awarded $900,000, but Bryant doesn’t expect to see the money. He says the company pursued legal action to provide further evidence that the report was a conspiracy and in the hope ASIC would be encouraged to pursue the matter offshore with US regulators, which it has declined to do. Its share price has since recovered, but Bryant is still angry about the disruption. “It adversely impacted the business for 12 months,” he says. “This remains a very live issue for all listed company directors.”

Repelling a surprise attack

Directors and advisers mostly follow the same playbook when a company is hit by short sellers — enter a two-day trading halt while the company investigates the claims and formulates a response to the activist report, which should be direct and concise.

Companies can, to some extent, prepare themselves for such an attack, says Sarah Turner, corporate advisory partner at law firm Gilbert and Tobin. They can monitor internet forums such as Hot Copper, which discuss their stock, and pay attention to the concerns of analysts and shareholders. “They’re aware of how to answer those kinds of issues and have often tried to answer them previously,” says Turner. “If that’s the case, they can often come out with a response that’s effective and pretty straightforward as they come out of the halt.”

Turner says that as a general rule, if a short seller’s report contains information that is both material and accurate, then it is information that should already have been disclosed to the market. However, that is rarely the case. “You tend to get a lot of reports based on things that are misleading or simply potentially misunderstood by the activists,” she says.

However, if the statement is not misleading, then directors need to ensure that any issues are fully disclosed before the shares come out of trading halt. Sometimes, this could mean bringing forward the announcement of initiatives that the board was already considering — such as taking a new strategic direction or exploring a new market. However, Turner says this has to be in the interests of the company as a whole; directors can’t just declare a special dividend to support the share price, for instance.

Preparedness pays off

Jeremy Lanzer, a corporate partner at law firm Arnold Bloch Leibler, says while there is nothing a company can do to prevent a short-selling attack, they can be prepared. They should identify matters short sellers might focus on, clearly explain them to shareholders and analysts, and maintain good relationships with important stakeholders.

“The better a company is at articulating how that works and getting people comfortable with what they’ve done potentially takes away some of the weaponry from these short seller activist firms,” says Lanzer. If an attack does happen, the company can point to its previous public announcements and statements and explain why the short seller has misunderstood or misrepresented a topic. Companies also need a team of external media and communications and legal advisers to call on.

Retail shareholders are particular vulnerable to short selling because while institutions have diverse portfolios and can sell a range of shares if they need cash, retail shareholders can’t, says Fiona Balzer GAICD, policy and advocacy manager at the Australian Shareholders Association. “For retail investors, that might be money you need for your house deposit or changing to a retirement income stream,” she says. “So somebody messing with your share price is much more harmful on an individual basis.”

She adds that while institutional investors have teams of people monitoring and analysing the share market, and can make better- informed decisions about a short-selling attack, retail investors are often busy with their daily lives.

An earlier version of this article stated that in Australia, a maximum of 15% of a company's shares is allowed to be shorted. However, in Australia there is no legal limit on a company's listed equities on issue which are allowed to be shorted. More accurately, the highest level of short interest in companies in the Australian market is generally around 15% of shares on