Editor’s Letter – Issue 140

April | May 2019

Hamlin Lovell
Originally published in the April | May 2019 issue

The ban on new short sales of Wirecard for a two-month period, by German regulator, BaFin, represented the first time it had restricted short sales on a single stock. The last time it banned shorting  the entire banking sector was covered in 2008, when a number of other European regulators did the same. In the interim, there have been shorting bans in particular countries, including in Greece on banks. European regulator ESMA has, as usual, concurred with BaFin’s decision. 

But this type of intervention is a threat to financial market efficiency, liquidity and price discovery. Whether or not any fraud is proven at Wirecard, its accounting, disclosure and investor relations policies are becoming more controversial every week as more unusual practices come to light – and investors should be able to express an opinion on valuation by going short. Currently, Slate Path Capital and Odey Asset Management have short positions above the public disclosure threshold (0.50% of Wirecard’s shares); others are thought to have smaller short positions. Historical shorts have included AQR; Marshall Wace, Theleme Partners and a pension fund – Canada Pension Plan Investment Board. 

Short sellers have often uncovered fraud that auditors missed. In her CFO.com article “auditing the auditor”, Acuity Forensics founder, Tiffany Couch, claims that, “external audits find it 4% of the time, and internal audits 15% of the time”, per the Association of Certified Fraud Examiners’ Report to the Nations. The reasons suggested are that auditors follow a statistical methodology, using materiality thresholds and sampling procedures, and are not sufficiently sceptical.

Hedge fund managers such as Muddy Waters founder, Carson Block, and Kerrisdale Capital’s Sahm Adranghi, both of whom featured in our ‘Tomorrow’s Titans’ reports, have most recently been associated with uncovering frauds in Chinese companies, as has Safkhet Capital’s Fahmi Quadir. Ben Axler’s Spruce Point Capital has identified problems at companies that ultimately failed, such as Miller Energy, whose auditor, KPMG, is now being charged by the SEC. In the UK, KPMG has been widely criticised for a number of audits and was fined in relation to its audit of Quindell, which was also a short position for some hedge funds. Back in 2002, Jim Chanos was short of Enron, a “glamour” stock with a high valuation that turned out to be a fraud. 

Short selling is probably the toughest hedge fund strategy. The average dedicated short seller has lost money over recent years, as measured by broad indices, though some smaller funds, including Eiad Asbahi’s Prescience Point Capital Management, have made extraordinary returns. These potential rewards are needed to incentivise managers to carry out forensic accounting and deep dive investigative research, while combating litigation and sometimes even death threats. 

Regulatory bans on short selling are, arguably, not consistent with the spirit of the European Union’s desire to strengthen protections for whistleblowers, who, like short sellers, have often discovered frauds and other wrongdoing – such as gargantuan money laundering by Denmark’s Danske Bank and Sweden’s Swedbank. We hope that BaFin’s temporary action will prove to be an aberration given that regulators generally recognise the importance of short selling.