Tuesday, 27 November 2012

Time to rethink rules on short-selling

Regulations that transcend national borders may be necessary
By Goh Eng Yeow, The Straits Times, 26 Nov 2012

ONE important lesson we have learnt from the global financial crisis is the way that a scurrilous rumour can destroy a perfectly good company very quickly.

All it takes is a few banks to panic and cut their credit lines when a company's share price collapses as the rumour goes viral.

Anyone with links to the company rapidly gets swept up in a wave of fear. There is no time to verify facts - just join the herd.

This results in a mad scramble by suppliers and customers to exit the stricken company.

In these uncertain times, who in their right minds would bother to check the truthfulness of a rumour? The top priority is to safeguard one's own financial interests first and ask questions later.

So when United States investment bank Lehman Brothers collapsed in September 2008, the US government took the unusual step of banning short-selling of key financial stocks altogether, for fear such abusive trading practices might cause the entire banking system to collapse together.

Short-selling is where investors sell borrowed stock in the belief the share price will fall - resulting in a handy profit if their prediction proves correct.

To the cynical, this looks a lot like rewarding corporate vandals.

Given the destructive forces which short-sellers can unleash on financial markets, it is surprising to find that there are not more rules in place internationally to regulate their trading behaviour.

Consider the way, for instance, in which some hedge funds build up big short positions and then try to herd other investors to drive down the share price - in a way that will help to make those bets pay off handsomely.

"Activist" hedge funds, as they are called, claim to play a vigilante role in the market, uncovering fraud in misbehaving publicly listed mainland firms, buying up short positions in them, and then publishing damning reports that aim to drive down the share price.

Some consider Muddy Waters Research, run by US lawyer Carson Block, to be a good example. The firm enjoyed spectacular success last year in accusing Toronto-listed Chinese timber concern Sino-Forest of misrepresenting its assets and fudging its records.

Sino-Forest shares fell 85 per cent within a month, wiping out big investors such as Mr John Paulson, the billionaire hedge fund manager. It later filed for bankruptcy.

Last week, Mr Block decided to go after a much bigger target - Singapore-listed Olam International, one of Asia's largest agricultural traders, by criticising its debt levels and accounting practices.

He chose his venue of attack well, delivering the opening salvo at the Ira Sohn investment conference in London whose participants included some of Europe's biggest hedge fund managers.

And he did not hide his intentions. "You should assume we are short on securities of Olam," he reportedly said.

Not surprisingly, Olam fought back vigorously, as it called for a temporary halt of its shares here and organised conference calls with the media and analysts to calm jittery investors.

As its chief executive Sunny Verghese observed: "We see a pattern in the way Muddy Waters and whoever they are working with, have taken a view on Olam, having built a significant short position and then coming up with this kind of report and using very aggressive and big statements."

"Shorting a company stock is not illegal, but manipulating the company's share prices in collusion with others is clearly illegal," he added.

On a more general note, the episode certainly raises a question here: If a local trader were to "short-sell" a listed company in a big way and then try to create panic by raising questions about its viability, would he have violated the Securities and Futures Act?

There is nothing wrong with an investment company pushing out research to try to add value to its investment portfolios. But in some cases, the business model seems to be to encourage the market to shift towards specific positions that benefit them.

Just consider the profit a trader may make from a well-placed short-bet which he then primes with a research report whose message has gone viral on the Internet, even though the veracity of the information in the report may prove to be lacking.

Some will argue a host of regulations are already in place to punish firms or individuals that spread misleading information on purpose, but enforcement is often difficult, if not outright impossible, if the erring parties are based outside a given jurisdiction.

It may be time to consider how regulations that transcend national borders can be devised to regulate companies producing research geared towards benefiting their own positions.

Leaving market forces to try to weed out the miscreant players may not be an adequate solution.

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