Friday, December 14, 2012

Short Sellers, Short-Termism and Corporate Governance

I have been following a corporate battle that erupted last month in Singapore. Muddy Waters, a financial research firm based in the US, released a 133-page report on Olam International, a Singapore-based company, alleging several accounting flaws in the company’s financial statements that did not represent the true state of its financial health. Upon this announcement, the price of Olam’s shares fell. It was found that Muddy Waters also simultaneously entered into short sales of Olam shares.[1]

Olam swiftly responded to the allegations in a number of ways. First, it issued a counter-statement responding to Muddy Waters’ allegations. Second, it filed a defamation suit against Muddy Waters before the courts in Singapore. Third, it announced a rights offering of securities. A rights offering is considered to be a defensive tactic employed against such short sale attacks on companies because the lenders of securities to the short sellers will then call back their securities so that they are able to participate in the rights offering. This battle is still ongoing, and it is too early to predict the possible outcomes.

While the above episode is specific to Singapore, Muddy Waters has initiated similar efforts on other companies by questioning their financial statements. For example, one of their targets, Sino-Forest, a Canadian-listed Chinese timber company had to file for bankruptcy following such a battle.

Such occurrences are not altogether alien to India. They have begun to take place here as well. The year 2012 has witnessed several analysts publishing reports regarding various Indian leading companies on matters that range from accounting practices to governance standards to the role of controlling shareholders. By highlighting issues regarding governance of companies, which extends beyond the traditional confines of financial analysis, these intermediaries are imposing considerable pressure on managements and controlling shareholders to reexamine their own governance standards and practices.

However, this phenomenon is very recent, and its impact on overall governance standards is yet unknown. In any event, certain recent reports issued by analysts have been surrounded by their own share of controversies. Not only have these reports been strongly refuted by companies and their managements, in one case a criminal complaint was even filed by the company concerned against the analyst firm and the individuals who authored the report.

The impact of these efforts is likely to be mixed. On the one hand, they will lend themselves to greater transparency on the part of the companies, as the availability of more information and deeper analysis will enable investors to take a more informed view of their investments. In other words, it creates a market-based approach that will likely enhance overall corporate governance standards, transparency and accountability on the part of managers and promoters of listed companies.

However, there is also another side to the story. There is no clarity whether these efforts by analysts and short-sellers will necessary inure to the benefit of the minority and long-term investors. Analysts with short positions are inherently conflicted as it is only their short term interests that motivate their actions. That might not be in the long-term interests of the company and its investors. Hence, it is likely that these efforts may benefit a short group of investors to the detriment of the larger investing community.

Currently, various scenarios are being played out through market forces via steps taken by the analysts followed by responses by the companies. If matters were to go out of hand (and there is not enough to suggest that yet), then it would be interesting to see whether the regulators would step in to moderate these contests.

[1] Short selling involves the selling of a security that an investor or a trader does not have in possession when placing the sale order in the system. A short seller borrows the security and then sells it in the market with an expectation that it can buy back the same security at a later date for a lower price than it was sold for. The difference in the selling price and the buying price would be the profit earned on short selling.

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