Over the past couple of years, short seller Muddy Waters LLC and similar research firms have broken out from obscurity by exposing alleged fraud and false accounting in companies like Sino-Forest, Focus Media Holding, Orient Paper, China MediaExpress, and others.
After Muddy Waters’ research precipitated the demise of Sino-Forest, which filed for bankruptcy in March and delisted from the Toronto Stock Exchange in May, the firm is now taking on the Singapore-based international agricultural commodities trader Olam International. In a newly released research report, it likens Olam to Enron in that there are “material similarities in the way their businesses developed” and their “aggressive” accounting. Olam refutes Muddy Waters’ findings and is suing the California-based firm.
So far so good, except that this covers only part of the story. Muddy Waters readily admits that some time prior to releasing its report, it had already shorted the stock. After Muddy Waters went public with its accusations, Olam’s stock price declined by 9.48% in a span of two weeks (19 November to 3 December). Some have questioned Muddy Waters’ actions, given concerns over possible conflicts of interests.
For our part, CFA Institute believes short selling plays an important role in market efficiency, enabling participants to quickly and accurately adjust securities prices to reflect investor opinions about valuations. We also have sympathy for the view that analysts, investors, and company executives should have skin in their respective games, be it their research opinions, investment positions, or company stock.
However, short selling can also trigger short-term market volatility and inflict severe damage to shareowners and investor confidence when stock prices fall. Even if research claims are unproven, the company in question is already put on the defensive to save its reputation, and could pay for the negative publicity with higher funding costs.
Good News vs. Bad News
Markets move asymmetrically with news: When you talk up a stock, it is unlikely you will move the share price significantly. But if you have negative things to say about it, you get an almost instantaneous downward price correction.
Several academic studies have shown this. A study by Helinä Laakkonen and Markku Lanne (2008) of the Helsinki Center of Economic Research showed that negative macroeconomic news increases market volatility more than positive news. Jennifer Conrad, Bradford Cornell, and Wayne Landsman, writing in The Journal of Finance (2002), found that individual stocks respond most strongly to bad news when the economy is performing well, while the reaction to good news is not greater in bad times than in good times.
Of course, any investment professional is free to publicly express opinions about a stock, a company, or an industry. But clearly these opinions should have a reasonable and adequate basis, and be supported by appropriate research and investigation, as stated in the CFA Institute Code of Ethics and Standards of Professional Conduct. We have been concerned for some time that allegations of ethical misconduct and the lack of objectivity and independence among research analysts weaken investor confidence in the financial markets and taint the reputations of all investment professionals.
Because of their power to move markets, it’s worth looking at the ethical considerations of these short-selling research firms — which almost always hold positions in the companies they are reporting on — and the seemingly grey area they operate in, with unclear regulatory supervision and accountability.
How are we to know that a short seller is not making wild claims in the name of “research” that benefits its position?
Muddy Waters says that it is not registered as an investment adviser in any jurisdiction. It tells users of its research reports to assume that the firm and its clients and/or investors have shorted the stocks it covers, but seemingly does not disclose how large its positions are.
Should the same rigorous compliance methods that apply to the research units of investment banks apply to research firms like Muddy Waters? To whom are they accountable?
Short selling already suffers from a bad reputation — governments around the world have banned it at various times for various reasons, including some that are entirely self-serving — and this reputation could worsen if shorting is hijacked by unethical firms and individuals who use “research” as cover for trashing a stock.
Investors’ trust in financial institutions, already suffering following the global financial crisis, could erode further if such unethical activities are permitted to thrive. Certainly the courts provide recourse if there’s any misrepresentation, but litigation can take years.
Analysts who abide by a robust code of ethics and rigorous standards of professional conduct are more likely to put their clients’ interests first and exercise their fiduciary duty. But some would argue that few analysts in established institutions provide the kind of in-depth research that firms like Muddy Waters do. Few bank analysts have uncovered fraud or accounting problems or rigorously questioned management’s assertions of the stocks they cover, as we have seen in the case of Enron and Lehman Brothers. Many feel that, in general, there are far too few “sell” recommendations that come out from the analyst community.
The rise of Muddy Waters and its peers could be a wake-up call to professional financial analysts, especially in Asia, to do their jobs more thoroughly and to take greater risks. It also might be a wake-up call for the investment community as a whole to be more aware of the dangers of reckless “research.”