On December 3, 2019, Japan’s Government Pension Fund (GPIF) announced that it would suspend share lending to short sellers. This is the latest development in a growing global regulatory skepticism of shorting, with Reuters recently reporting that short selling bans are under consideration in South Korea, Germany, France, Italy, and Turkey. Prominent short activists have characterized these regulatory efforts as a “war on truth,” calling themselves modern-day Davids fighting corporate Goliaths, powerful companies who commandeer protectionist instincts to shield local industry from legitimate criticism.
To be sure, a large academic literature has found that short selling improves price accuracy. From Enron to Theranos, when corporate fraud dominates the headlines, short sellers, journalists, and whistleblowers point to the lack of skepticism and contrarian sentiment in the market as giving rise to the stock-price crash that destroyed the savings of ordinary mom and pop investors. Put simply, short sellers pop bubbles – bubbles that induce a frenzy of buying, distort the allocation of capital in the economy, and leave a trail of destruction in their wake.
On the other hand, there are reasons to be skeptical of short sellers. In September 2018, the SEC charged a hedge fund adviser, Lemelson Capital Management, with illegally profiting from a scheme to drive down the price of a public company, Ligand Pharmaceuticals. My research has shown that online attacks by pseudonymous authors are followed by stock-price reversals and options trading patterns suggestive of market manipulation. On August 15, 2019, Harry Markopolos accused General Electric of being “A Bigger Fraud than Enron,” leading to a sharp stock-price decline, which subsequently reversed as soon as analysts, investment banks and reporters came to the conclusion that the Markopolos report was unfounded. Just one month later, the website gefraud.com was taken down and replaced by an error page.
How might we distinguish between legitimate short selling and manipulative short-and-distort campaigns? One place to start is the duration of an activist’s short position. For over a decade, long-side hedge fund activists have been criticized for short-termist trading strategies which elevate quick profits over building the fundamental value of a company. While short activists seek to identify overvalued stocks rather than improve fundamental value, these campaigns invite a similar kind of short-termist trading strategy.
The parallel between long- and short-side activism is the focus of a terrific new article by Barbara Bliss, Peter Molk, and Frank Partnoy, who argue that negative activists play an important complementary role to traditional activists in enhancing price accuracy. But much as stock prices might overreact on the upside to an engagement by a traditional shareholder activist, a firm’s share price might crash too low – relative to the company’s fundamental value – upon the announcement by a well-known short activist of a campaign against the company. To be sure, activists may claim that they bear little responsibility for overreactions by other investors. But there is certainly no reason to reward shorts for inducing a short-lived run on the stock driven by panic and hysteria.
Just as there is a growing recognition of the need for shareholders to focus on long-run value creation, so the corporate governance community should insist that short sellers promote long-run price accuracy rather than short-term trading profits. But here’s the rub: Long-term short selling is notoriously expensive because short sellers must pay interest on borrowed shares. Steps to restrict the supply of shares available for borrowing, like the GPIF’s suspension of share lending, might have exactly the opposite effect of what is intended, making it more expensive – not less – to engage in long-run campaigns that advance a deeply researched, sustained negative thesis on a company.
Moreover, lending to long-run short sellers is likely to advance, not hinder, an institutional investor’s stewardship interests. For example, making it cheap to short CO2 emitters is consistent with a commitment to environmental, social, and governance investing. Indeed, the shareholder vote might well be a kind of “cheap talk” compared with lending shares at a discount to socially responsible long-run short sellers. In addition, it is possible that the growing trend of passive investing injects a kind of buy-side bias into the market. Lending shares for long-run short selling is a corrective, compensatory measure that institutional investors can employ to counteract the inflationary effect of buy-and-hold indexing.
That said, the GPIF’s concerns over insufficient transparency in share borrowing are compelling. It would be easier for share lenders to screen out manipulators if more countries were to embrace regulatory efforts to combat abusive campaigns, like the French proposal to require greater disclosure of derivative positions and encourage specialized review of market manipulation claims. Similar proposals are found in my recent discussion paper on social media, short activism, and the algorithmic revolution for the New Special Study of the Securities Markets: Columbia / FINRA Technology Conference. The right policy goal is not to eradicate short sellers – but to encourage them to hold for the long run.
This post comes to us from Joshua Mitts, who is an associate professor at Columbia Law School and consults on litigation and regulatory matters involving short sellers and market manipulation.