Short selling — now there are two words that can plunge an icy dagger into the emotional heart of an investor.
In itself, there’s nothing wrong with selling short. If you honestly believe a stock is overvalued, based on honest reporting and analysis, then by all means borrow some shares and sell them — in addition to hopefully enriching yourself, you’ll also be helping our economy in its quest for efficient allocation of capital.
But short selling can be a damaging tool, and in the short term it has the potential to destroy promising new companies.
Look at what happened to Quindell (LSE: QPP) last month.
Damaging report
The mysteriously named Gotham City Research released a report that condemned Quindell shares to a valuation of no more then three pence — though they currently change hands for around 21p. The so-called research slated the company’s prospects as being built on sand. How was the report publicised? By Twitter, that’s how.
Something reportedly admitted right away was that it should be assumed that Gotham City would benefit from a falling share price — so we were looking at a someone with a declared interest in Quindell tanking, publicising a scathing attack on the company? Hmm.
For its part, Quindell published a quick rebuttal, calling the Gotham City report “highly defamatory” and “deliberately misrepresentative” — and the company went on to launch legal action and pointed out that large short positions had been taken ahead of the publication of the report.
Quindell is set to report the episode to regulators, too.
Blinkx too
We saw a similar situation here with the Fool’s Beginners Portfolio not so long ago, when a Harvard Professor, Ben Edelman, published a withering attack on video-technology specialist Blinkx (LSE: BLNX). Blinkx, not unsurprisingly, robustly defended itself against the professor’s allegations of unethical practices — but the shares crashed by 40%.
Now, Professor Edelman’s report was paid for by two unnamed investment companies, and he later admitted that the terms of his contract meant that “If I find nothing, there will be a discount“. So he’s admitting to being paid to report negatively on a company?
We don’t know who paid for this, but five hedge funds that had short positions have reduced their exposures since the report was published.
What is to be done?
It’s tough to regulate shorting and conflict-of-interest reporting, but the FCA does have powers to deal with market abuse (at least in the UK). And European Securities and Markets Authority regulations can kick in whenever there’s a negative swing of more than 10% — and a “competent authority” is supposed to have the ability to take action. But I’m not holding my breath.
Dirty business
I’ll repeat my support for honest short-selling, but when there are powerful investors around who can make a pile from putting an undeserved short-squeeze on a company (and it’s always a vulnerable small company — you couldn’t do it with the blue chips), well, it can be a dirty business.