When Short-Sellers Attack: Tips for Investigating Activist Investors

December 2012

IN THIS ISSUE

— Making Money From News: How Short-Sellers Operate
— Information Protects Against Information: How to Defend Against Short-Sellers

GREETINGS!

Welcome to the December 2012 edition of our newsletter! In this issue, we’ll examine how activist investors looking to change (or control) a public company’s leadership can use negative events or information to their advantage, and what your company can do about it.

MAKING MONEY FROM NEWS: HOW SHORT-SELLERS OPERATE

In addition to the traditional position of holding a public company’s stock for a long period of time in hopes for capital appreciation, investors can also “short” a stock — buying positions, using borrowed funds, that essentially bet that a stock’s price will decline to a certain percentage by a certain date. If the purchaser is correct, they can repay the loan and reap substantial profits — if the stock rises in value, the loan must still be repaid at the maturity date, which can lead the purchaser to take a substantial loss on the investment and force them to use other assets to repay the loan.

Investors who take short position can either be looking to make a quick profit and exit their position, or — as in more often the case in large institutional investors — a purchaser can attempt to use successful short positions to obtain oversize influence (often millions of shares) at a reasonable cost, thereby seeking to aggressively promote its proposals at shareholder meetings and often by obtaining board memberships and key committee assignments on that company’s board.

INFORMATION PROTECTS AGAINST INFORMATION: HOW TO DEFEND AGAINST SHORT-SELLERS

Short-sellers will often take their positions early in a negative event’s news cycle, betting that the market has yet to fully digest the severity of bad news — and that their short positions will grow as that process reaches fruition. The accounting scandals of the early 2000’s,. from Enron to Tyco, provided opportunities for short-sellers to profit handsomely. While many short-sellers rely on publicly available information, some use insider tips to fortify their predictions, while others have third parties disseminate negative (even blatantly false) information about a company or its executives to drive a stock price down.

What can be done to combat aggressive tactics by the holders of short positions? Since that market is more opaque than the market for long positions — and since many of the larger such investors operate entirely or in part via overseas tax havens with lax disclosure rules — tracing ownership can be difficult, but a tenacious researcher can assist your firm in identifying the parties operating the companies that make such purchases. From that point, due diligence profiles — focusing on prior litigation, regulatory actions, news articles, and previously disclosed positions, both short and long — can help identify conflicts of interest, adverse events and other items that can help your firm prevail in the court of public opinion, and hopefully mitigate any damages short-sellers might be able to inflict.