Securities regulators have long targeted “pump-and-dump” schemes that aim to drive up stock prices with baseless hype. Now, regulators are going after so-called “short-and-distort” campaigns, in which short-sellers badmouth companies in an effort to drive down stock prices.
Certain Bay Street factions have long complained about the role of short-sellers in the Canadian market. More recently, there have been concerns about the threat of activist short-sellers — traders who don’t just quietly bet against companies they see as overvalued, but broadcast their views to the rest of the market.
Critics complain that activist short-sellers can make baseless allegations against a company in order to drive down its stock price and lock in an easy profit. Defenders of the practice argue these gadflies can help expose corporate misconduct and serve as an important check on the overwhelmingly positive bias in mainstream analyst coverage.
The most notorious recent example of this in Canada is Sino-Forest Corp., which traded at around $20 back in mid-2011 until U.S. hedge fund Muddy Waters LLC issued research alleging that the company was a massive fraud. The stock price plunged in the wake of those allegations, ultimately reaching zero when the hedge fund was largely proven right.
However, critics worry that most activist short-selling activity isn’t nearly as accurate or helpful.
A new consultation paper from the Canadian Securities Administrators (CSA) solicited feedback on whether the concern about activist short-sellers is warranted — and what, if anything, needs to be done about them.
The CSA paper, which is out for comment until March 3, 2021, outlines concerns that activist short-selling is on the rise in Canada and that in general, Canadian regulators’ attitude regarding short-selling is lax. The CSA paper noted there currently is no real deterrent to baseless attacks by short-sellers, given that there has been little successful enforcement activity against them.
Despite the perception that short-sellers’ activism is on the rise, the CSA’s analysis found that the activity remains low relative to in the U.S. There was an average of five activist short campaigns per 1,000 listed companies over the past 10 years in Canada, well below the average of 21 targets per 1,000 firms in the U.S. over the same period.
In addition, the trend in activist campaigns seems to be cyclical. For example, while there were 21 activist short-selling campaigns in 2016, there were only nine in 2017 before the number jumped to 22 in 2018, then dropped to seven the following year. So far in 2020, there have been 13 activist short-selling campaigns in Canada, according to research by New York-based Activist Insight Ltd.
The CSA paper suggested that short-selling activism follows the markets, responding to perceived overvaluation. For example, the jump in activity in 2018 followed the flourishing of the cannabis sector: pot stocks accounted for 35% of the companies targeted by short-selling activists that year.
While short-selling activism may not be as extensive as critics suggest, the CSA paper acknowledged that some believe Canada’s regulatory system is overly tolerant of the activity.
Short-selling rules in Canada differ from those in the U.S. and Europe, but the CSA maintains that the Canadian system meets the global regulatory standards set by the International Organization of Securities Commissions.
Nevertheless, the CSA consultation paper asked whether Canada’s approach needs to change. For example, the paper asked whether increasing disclosure obligations on short-sellers would curb abusive activity and give other investors and issuers more information about an activist’s positions.
At the same time, the CSA paper cautioned that added disclosure requirements on short-sellers could have unwelcome side effects, such as exposing traders’ strategies and opening short-sellers to increased legal and regulatory risks. Given that short-sellers already face inherent obstacles — from potentially unlimited risk inherent in an unhedged short to the cost of borrowing the securities to cover a short position — regulators worry that adding further disincentives may stifle legitimate short activity, thus harming market liquidity and price discovery.
The CSA also is examining the role of enforcement in preventing abusive short-and-distort behaviour.
To date, there has been little regulatory enforcement against activist short-sellers who claim a company is a fraud. When regulators have tried to bring cases against activist short-sellers — such as the Alberta Securities Commission’s (ASC) attempt to secure a cease-trade order against short-seller Marc Cohodes in 2018 — those efforts usually fail.
Proving that an activist short-seller has violated securities laws not only requires regulators to establish that the activist made false statements, but that their actions had a material impact on the market. The use of social media complicates this process: it’s not easy to prove that someone yelling on Twitter was the reason a stock’s price dropped.
In the Cohodes case, for instance, the ASC dismissed its enforcement staff’s argument that Cohodes’ negative tweets about Calgary-based Badger Daylighting Ltd. had a significant impact on the company’s stock price.
In cases in which specific regulatory violations can’t be proven, Canadian regulators have declined to invoke their public interest jurisdiction to shut down activist short-sellers, fearing that such a measure could suppress legitimate investor skepticism.
Not only has there been little regulatory action against activist short-sellers, there also isn’t much recourse from the courts for issuers — or for investors holding long positions — to try to claim they’ve been hurt by short-and-distort campaigns.
For example, there’s no equivalent of secondary market liability — which enables investors to sue issuers and their top executives for misrepresentations in their public disclosure — that can be applied to short-sellers. Instead, according to the CSA paper, most of the legal efforts against activist short-sellers in Canada have been brought as libel or defamation claims.
The CSA is contemplating a need for a more effective way to hold activist short-sellers accountable. Among other things, the CSA’s paper floated the idea of adopting a new standard for enforcement action — one that doesn’t require proof that a short-seller’s statements about a company had a material negative impact on its stock price.
The CSA paper also asked whether a new statutory right of action is needed to enable companies to sue problematic activists more easily. However, the CSA paper cautioned that this could have unintended consequences, such as discouraging mainstream research analysts from being honestly critical of the companies they cover.
Ontario’s Capital Markets Modernization Taskforce is likely to address activist short-selling in its final report to the provincial government, which is due before the end of this month. The task force’s draft report proposed creating a specific legal prohibition against making false or misleading statements about public companies to combat both pump-and-dump and short-and-distort campaigns.
The task force is particularly concerned about the potential for social media to spread misinformation about a company. The draft report suggested creating a specific provision in the law will give regulators stronger grounds for taking action against efforts to drive stock prices up or down with false information.
In a world that wants to see markets only rise, short-sellers have never been popular — and policy-makers may be about to make their lives tougher.