Pulling Back the Curtain on China Short Sellers

“We welcome the new bull market,” John Hempton, known for being ultra-bearish on Chinese stocks, recently told Reuters. “We hope they issue hundreds of new shares because they will provide our future happy hunting ground.”

Short sellers, you will recall, were the investors who decimated the valuations of Chinese stocks over the past few years. Their blistering attacks caused one-time highfliers like Longtop Financial and Sino-forest to completely implode. Other Chinese companies like Focus Media and Harbin Electric chose to go private after they were (unfairly, in their view) damaged by constant accusations of wrongdoing.

Despite the revival of investor interest in Chinese IPOs, the specter of short attacks creates the risk that this may again be a short-lived party followed by an extended hangover of shareholder lawsuits, de-listings, and SEC investigations.

So who are these short sellers?

While short selling is not permitted in China’s domestic stock market, in most mature financial markets it serves as a correction for investor exuberance. If a stock’s price soars far above its underlying value then short sellers can profit by borrowing the shares from a long investor, selling those shares short, and buying them back at a lower price once the share price declines.

Short sellers can help provide efficiency to a market by sniffing out where management may be overly optimistic about a company’s prospects or where economic conditions are deteriorating.

In China, short selling has evolved to become a blood sport. Often the “analysts” will issue scathing, voluminous reports that argue that a Chinese company is not just overvalued, but is an outright fraud, that must be destroyed, with a value of zero.

These short sellers have often taken the moral high ground, claiming that they are helping to protect unsuspecting U.S. investors from unscrupulous Chinese companies out to fleece them. They will often accuse these companies of factually misrepresenting the nature of their businesses, inflating results of operations, having hidden relationships that obscure who benefits from financial transactions, and being outside of the reach of effective regulation.

However, many of these claims could also be made about the short sellers themselves.

Most of the analysts who have issued short reports on Chinese companies exist in an obscure netherworld of anonymous websites or blogs, with limited ability to contact or verify the identities of those behind the research. They have names such as Muddy Waters, Absaroka, Citron Research, Alfred Little, Gravity Research and Glaucus Research. In most cases, these analysts have not registered with U.S. regulators such as FINRA or the SEC.

Often, these entities have close relationships with much larger funds that collaborate with them in a short-selling campaign.  These funds may pay to get advanced notice of a pending report. While security analysts at investment banks are prohibited from sharing their research with clients in advance of publication, unregulated short analysts are exempt from such restrictions. In some cases funds will conduct extensive research to support an attack and then hand all the information off to a “short analyst” to add their research, polish and publish the results. The analyst may negotiate and be allocated a chunk of the short position that has been built up or be paid to serve as the public accelerant of the raid. The true extent of these cross relationships are rarely disclosed to the public.

While funds are required to report anytime they buy over 5% of outstanding shares, there are currently no reporting requirements for short selling. Thus management and other smaller investors are left in the dark as to these funds’ trading activities.

For example, a short seller could very well build a short position in advance of the publication of a short report and then close out that position when the shares plunge on the first day, before the company has had a chance to respond to the accusations. A fund might even turn around and go long the next day, buying the shares cheaply from panicked retail investors and ride it back up as market confidence recovers.

Short selling can be an expensive and risky proposition.

Often funds invest substantial resources to comb through legal documents, interview employees and customers, or perform covert surveillance of a company’s facilities in order to build a convincing case that something is amiss.

Short sellers also have to pay fees, known as “negative rebates,” to borrow shares at rates that can run from 20% to 180% annualized interest for heavily shorted Chinese stocks. When a company issues a dividend, the short seller needs to pay it to the investor that owns the shares. And if the stock ends up getting halted by the stock exchange, they risk getting stuck for months without being able to close the position. In comparison to a long bet where the risk is limited to the investment, shorts losses can be infinite. Short selling is best described as a business rather than a gamble. The revenue stream generated by the report has large offsets such as the research and borrowing costs. But when the target is a Chinese company, short sellers have a very high probability of success, at least in the short term. Typically the reports contain dozens of allegations that support the theory that the company is a fraud and involves complex issues that may be difficult to disprove. In addition, foreign investors may find it challenging to conduct due diligence and verify basic information in China. Many Chinese management teams have done a comparatively poor job in communicating their business plans, internal controls and corporate governance.

To be successful, a short analyst only needs to convince investors that a fraction of the allegations are true, whereas company management is rightly held to the standard of 100% accuracy.

If the new wave of Chinese IPOs is to be sustained, it will require that all of the market participants step up their game. Investment bankers, auditors and legal advisors need to live up to their “gatekeeper” role of discouraging flawed companies from going public. Corporate management must take responsibility to fully and accurately describe their business and disclose anything that might remotely look like a conflict of interest or self-dealing.

In the same vein, short sellers should be subject to a reasonable degree of transparency, so as to discourage reckless attacks, decrease the potential for market manipulation, and level the playing field for individual investors.

Short selling analysts should be required to disclose their research at the same time to all investors and to be subject to some level of regulatory oversight. Funds should be required to make periodic filings about their short positions, and disclose if the position of a fund or a group of investors acting in concert goes above certain threshold levels.

Supreme Court Justice Louis Brandeis famously said, “If the broad light of day could be let in upon men’s actions, it would purify them as the sun disinfects.”

Today, Chinese companies and professional advisors are quite rightly being held to the highest standards of transparency. It is only fair to ask that the short sellers also come out of the shadows.

About the author

 Drew Bernstein is the Co-Managing Partner of Marcum Bernstein & Pinchuk (MarcumBP), and a recognized expert in issues related to doing business in China, accounting and financial due diligence, and cross-border M&A. MarcumBP provides a range of services to both Chinese companies looking to expand overseas and U.S. companies with operations in China, including audit, financial due diligence, internal controls, risk management, international tax strategy, and transactional support services.