Views on improving the integrity of global capital markets
07 December 2012

Short-Selling Investment Research Firms like Muddy Waters: Manipulating or Aiding the Market?

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.”

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About the Author(s)
Paul Smith, CFA

Paul Smith, CFA, is the founder of SustainFinance and the former president and CEO of CFA Institute. He has more than 25 years of relevant financial services leadership experience in many aspects of the investment management industry.

15 thoughts on “Short-Selling Investment Research Firms like Muddy Waters: Manipulating or Aiding the Market?”

  1. Stefano R says:

    I think Muddy Waters, Citron Research and other research firms did a good job in uncovering all these chinese RTO frauds. They profited from it, but they also helped investors to avoid losing more money.
    I invested in some chinese stocks because I was attracted from the low valuations, financial statements looked good, China was the place to be few years ago, and I thought SEC, the Big 4 were doing their job in protecting investors and in auditing. I ended up losing nearly all my money but I learned a lot of things that hopefully will help me in the future.
    There is no free lunch in the markets and I should have paid attention to all those nice, low valued businesses in China. Strong revenue growths, strong earnings, low debt, a growing market in terms of population and spending, a positive currency exchange trend etc.. it was just too good to be true.
    SEC and other regulators (CFTC, NFA, FSA etc) are unfortunately often not able to prevent these frauds from happening, when they discover them it is often too late.
    I praise MW, Citron, Alfred Little (The financial investigator) and others for their contribution in making the financial markets a safer place, but I also think there should be more transparency on their trades, after a report is issued. They had a good success ratio in the past, but in the past few months some companies, like Focus Media Holding, were able to withstand MW’s allegations… if MW’s allegations were false, should they be accounted for the damage created? I think yes, so I think they are pretty cautious before issuing these researches, but if they are wrong one time, they may end up paying in damages all what they have earned in the past years.

    So basically shame on SEC,other regulators and Big 4 audit firms, bravo to MW and the other research firms for making the markets more efficient.

    1. Paul Smith says:

      As you say, not all of Muddy Waters’ exposes have yielded the results that they would have liked. If Olam goes against them, then their batting average will not be that impressive. Not all China-related stocks listed overseas are frauds. Many managers are currently focusing on the discrepancy between the negative public impression of Chinese stocks listed abroad (especially in the U.S.) and the reality that many of them are perfectly good names to own. Sorry you have had such a bad experience!

  2. This is a well balanced and thoughtful article that fairly addresses many of the primary issues. I would like to add to it based on my experience as an equity analyst and as a researcher in to Chinese accounting fraud at the Chinese University of Hong Kong.

    1) As you have correctly suggested, there is the issue of proof behind the fraud claims, which most short sellers try to provide but of course it is not an independent source. In many cases company independent audit committees are either non-existent or hopelessly inadequate. It is highly debatable whether tax filings, such as SAIC, are reliable sources, and they are no longer publicly available anyway, and are only suitable evidence for certain types of fraud. The best independent proof would come from government regulatory investigations, particularly with access to audit papers and bank transactions, however so far this has not been possible in countries such as China. So we are now in a limbo land of not knowing whether many short seller claims of fraud are wild or indeed true. I agree that some unproven claims of fraud could well be wild, but equally that does not necessarily mean there was no fraud. It is a difficult situation.

    2) Whilst short sellers may well have limited accountability relative to other analysts, they do clearly state their intention via their short position, and set out their case in their reports. So there is high visibility in this respect for investors to make decisions knowing the short seller motives and their story. Moreover, given that a number of investment bank research units did have “Buy” recommendations on certain companies that were later shown to be fraudulent, we have to ask ourselves whether their recommendations were any more reliable, albeit for different reasons such as being misled by company management.

    3) Nevertheless, many investors are not well equipped with the appropriate analytical tools to confidently tell the difference between a fraud and a well behaved company, or to decide if a short seller claim is likely to be true. This could explain why apparently good Chinese companies also suffer value falls, because many investors have less certainty about what they are buying. I spent a lot of time researching various accounting red flags that have enabled me to make better informed decisions, however this required considerable knowledge of equity analysis, operational issues, accounting & auditing, Chinese/Asian business culture, company law, taxation, fraud strategies, etc. There needs to be greater familiarisation amongst investors with such issues so they can conduct their own due diligence, and less reliance on other sources.

    4) I do not see this problem getting any better. Many of the historic fraud cases that have been exposed were the more obvious. The accounting red flags were very clear. It is easy to uncover a fake business, but much harder to detect a cash round tripping scheme via the Cayman Islands, or a network of undisclosed related party transactions tunnelling shareholder assets out of the company. Detection techniques are largely based on historic cases, however fraud strategies are Darwinian and evolve in their sophistication to circumvent such discovery methods. This makes it even harder for investors to identify the difference between good and bad companies, and to verify short seller claims.

    I invite the author or anyone else with a professional interest in this subject to contact me via LinkedIn.

    John Besant-Jones

    1. Paul Smith says:

      Many thanks. Your comments are very thoughtful and appreciated. I hope someone who is better qualified than I will give a more valuable response.

    2. James says:

      hello may i find out what is the possible unethical conflict of interest for these short selling research firms when they sell short and made the decision to disclose negative news about the firm?

      1. Paul Smith, CFA says:

        James, depends upon how they are remunerated and whether they have a declared position in the stock prior to writing the report. I think the problem lies in the asymmetry of response to negative as opposed to positive information. Easier to get a stock to sell off than it is to get it to rise in value.

  3. Pranav Kale says:

    The reason why markets move asymmetrically with news – more in case of bad news – is that the business news media is skewed towards positive news.

    So the warning signs i.e. initial bad news is ignored till it builds up and manifests itself in the form of shock which leads to a sudden fall in the market or the stock price of an individual company.

  4. Alan Brochstein says:

    Excellent article. This is an area of increasing importance. Your article seemed focused perhaps on Asia, but I think the broader topic of the grey area of using social media to promote one’s views (positive or negative) is quite interesting. By the way, I would add Off Wall Street to the list of companies that take positions then publicly disseminate their overall rating (without details). What I like about Citron is that they at least share their rationale.

  5. Alex says:

    Great insights on short-selling research firms!

    However, I would like to ask if short-sellers are generally independent or have any affiliations to firm clients, broker-traders or investment bankers.

    For the case of Muddy Waters, it distributes free research reports to the public. So their revenue model is to take a short position before publicly release their research reports for the other investors to act on it. So what is their ultimate purpose? Is it to profit from short-selling or inform the public about the accounting misconduct of these fraudulent companies or the best of both worlds?

    Are they considered as CFAs and subjected to the code of ethics?

    Thank you!

    1. Paul Smith, CFA says:

      Alex, if they are CFA charterholders then they are subject to the Code of Ethics just like anybody else.

  6. Plato says:

    I think that the subject deserves debate.

    However, I don’t think they should be regulated any more than anyone else. In my opinion, company executives and the sell side have big incentives to promote their companies.

    I disagree that most investors aren’t equipped to make the difference between information manipulation and substantiated facts.

    If substantiated facts create more volatility in the market, so be it. It would show that volatility, in and of itself, isn’t a measure of market efficiency.

  7. capricorn_ktl says:

    When Muddy Waters made claim that NQ practices massive fraud, the prices dropped more than half in a single day. Many lost millions. The result of independent investigations of the alegation have found no Massive Fraud or any fraud at all. Who is responsible for those who lost their fortunes? Is Muddy Waters? Is Muddy Waters benefits from this?

    1. Paul says:

      Aren’t you a bit behind on that comment? have lost 80% since…so why was Muddy Waters to blame if the market feels the company to be worth way less than the loss that you cite?

  8. Dear Paul,

    Fully agree with your views.

    Muddy Waters has continued its work since your article.

    The two stocks it has publicly shorted recently are AIM London-listed Burford Capital in 2019 and NMC Health in 2020. The nice thing about MW is that it publicly discloses its research methods, its detailed short rationale and makes accusations only when it is a hundred-percent certain.

    We need more short sellers like MW to help get rid of unethical entrepreneurs who cheat investors. I am glad that there are now more short-sellers like MW.

    Short-sellers like MW bring the much-needed sunshine in the stock markets

    I have used MW short-selling cases in my training of budding finance professionals.

    Arvind Mathur, CFA Charterholder

  9. Dear Paul,

    Just re-read your article.

    A nice point you make is: ‘few analysts in established institutions provide the kind of in-depth research that firms like Muddy Waters do’

    Most investment bank analysts give many more buy recommendations relative to sell recommendations. That is a bigger problem of ethics in the investment world as compared to the well-researched sell recommendations of short sellers.


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