Short sellers: the new anti-heroes of ethical investment?
In early July, a cub reporter who had only left university the year before filed a story that would cause UK fast fashion company Boohoo’s share price to tumble.
Vidhathri Matety went undercover for the Sunday Times at a factory in Leicester that supplies Boohoo. He found workers were being paid less than half the minimum wage and given little protection from coronavirus. Over the next few weeks, Boohoo’s share price fell by as much as 45%.
A few months before, a UK short seller dubbed the ‘Dark Destroyer’ for his reputation of sinking companies’ share prices had also published a report on Boohoo. Matthew Earl of ShadowFall, whose mantra is “seeking hidden truths within the major equity markets” and who had been a prominent critic of the defunct German payments company Wirecard, had been circling Boohoo for some time.
On May 25, he published a 53 page report which excoriated its corporate governance, while questioning its free cashflow and profit margins as well as its relationship with another company, Pretty Little Thing, which Boohoo took full ownership of in May.
It was a classic short seller’s report: bristling with devastating detail on the company’s financial accounts. And yet, Earl did not torpedo the stock with that report. It fell 6.8% in the two days after it came out, but then rose 15% the following day.
In fact, between Earl’s report and Matety’s article in July, Boohoo’s share price rose 7.8%, giving it a market capitalisation of over £5bn.
Earl’s report did not go into the working conditions at Boohoo’s suppliers, even though human rights organisations had been warning about conditions in the fast fashion industry for some years. What punctured Boohoo’s share price was the journalist’s report.
Earl, who is still short Boohoo and wrote a subsequent piece about Boohoo in September which references the Sunday Times article, said in response to GlobalCapital’s emailed questions that he was “unaware of how appallingly bad the conditions were at a number of the suppliers. However, we had a view that there was something amiss in the supply chain, mainly due to the fact that these issues had been raised before and the profit margins were so conspicuously high relative to Boohoo’s peers.
"In our view, the allegations raised were incredibly damning and this is why the share price reacted as it did.”
The journalist, in other words, had found Boohoo’s weak spot. But Earl made another point: “The real damage to the share price appears to have been driven by an initial lacklustre response by the company to the allegations,” he said. “We believe this gave an impression to the market of indifference.”
The story points to what could be a new feature of the landscape for short selling investors. Environmental, social and governance (ESG) issues are increasingly monitored by mainstream investors — even if imperfectly — and by the public at large. This could open up a new set of opportunities for short sellers as champions of ESG probity.
Carson Block of Muddy Waters
New playing field
Activist short sellers — the most famous of which is Muddy Waters — have proved more effective than many much bigger institutions at uncovering frauds and corporate deceptions.
Over the past decade, there has been a surge in so-called ‘short attacks’, in which an investor releases a scathing report on a company, accusing it of fraud, corruption, misleading investors or mismanagement. The investor has already sold the shares short and hopes to make a profit when the share price falls.
Typically, activist short sellers have homed in on complex financial frauds, often aided and abetted by aggressive accounting.
Whether short sellers will become more alert to ESG issues will depend partly on whether they see a financial incentive in doing so. A short seller must do more than sniff out a significant problem in a company that others haven’t spotted. The trick only works if others actually care about the problem once they hear about it.
Carson Block, the feared chief of Muddy Waters, believes there’s potential in targeting companies on an ESG basis. “There’s an opportunity in ESG, in that there’s a number of companies masquerading as ‘E’ that really aren’t,” he told GlobalCapital. “ESG funds are indiscriminately dumping money into whatever seems to be green, and the shorting opportunity goes something like: ‘these guys say they are saving whales and, no — they’re actually killing whales and turning them into smoothies’. With a report like this, you try to inform the actively managed ESG flows.”
Basic facts would suggest that the wider capital markets are becoming more attuned to ESG issues. Certainly, ESG investing is growing rapidly. There are many ways of measuring this, but according to a Broadridge report in September, there are around $1.3tr of assets in ESG funds globally.
This means companies seen as having strong ESG credentials can get a lot of support from the market. Several ESG funds had backed Boohoo, including some managed by Standard Life Aberdeen and Legal & General Investment Management. Boohoo had a double-A rating from ESG rating agency MSCI.
When the illusion of virtue is shattered, such a company’s fall can be harder — good news for short sellers.
On a roll
Another company that excited ESG investors is Nikola, which is developing electric and hydrogen-powered trucks. It went public on the Nasdaq in June via a reverse merger. The enthusiasm pushed its market cap to $30bn soon after it floated.
Hindenburg Research, a US short selling fund run by Nate Anderson, issued a damning allegation against the company on September 10. Its 67 page report suggested Nikola’s claims to extensive proprietary technology were misleading, and that Nikola’s chief executive had overstated its technological progress.
It highlighted a video Nikola had marketed of one of its trucks driving at speed. Anderson said the truck had simply been towed to the top of a hill and rolled down in neutral. Nikola said it had “never stated its truck was driving under its own propulsion in the video”. But it denies the allegations of securities fraud made by Hindenburg and said it had “contacted and briefed the SEC regarding Nikola’s concerns pertaining to the Hindenburg report”, which it called “false and defamatory”.
The report precipitated Nikola’s market cap to plunge from $19bn to less than $10bn.
In this case, the alleged flaws at Nikola are not really of an ESG nature, but the stock had been pumped up by eager ESG investors, which then had second thoughts.
As with Boohoo, Nikola’s case suggests ESG demand for a company can drain away quickly.
“While an ESG angle is unlikely to be the only argument to warrant a short position, we see it as an increasingly significant aspect to merit attention,” said Earl. “This is due to the sizeable flows that we have witnessed into funds that claim to use an ESG approach as part of their investment framework.”
The flipside of the present thirst for ESG investments is fear of greenwashing. According to a report in October by NN Investment Partners, as many as €660bn of green bonds are already outstanding; they expect that figure to reach €2tr in three years. But in that same report, NN’s researchers argued that only 85% of this debt deserves the green label.
There are large numbers of investors out there, therefore, whose faith in a stock can be dented.
But Earl is conscious, too, that — as with any short selling attack — sometimes, the intended audience of mainstream investors does not listen. He admonishes investors: “ESG-minded fund managers need to be true to their word if it is discovered that the ESG criteria falls below their expectations and [the criteria of] those that have invested in their funds.”
Anne Stevenson-Yang of J Capital also has her doubts. “I believe people should disinvest [from unethical companies] but I doubt they do,” she said. “If you’d shunned cigarette companies since 1990 you’d have lost out on a lot of profit. [But] when companies actually violate the law, that’s a different issue.”
Asked if the case for shorting on an ethical basis was contingent on companies breaking the law, Stevenson-Yang said: “Maybe. Probably not even that. You need legal action against them. Fund managers are such whores.”
Gabriel Grego of Quintessential Capital
Observers might be sceptical of this, but for short sellers, it’s not always just about the money.
“To me, the ethical side comes first,” said Gabriel Grego, a short seller at Quintessential Capital, known for his campaigns against Greek jeweller Folli Follie and Canadian cannabis company Aphria, which he teamed up with Hindenburg’s Nate Anderson to uncover. “My investment strategy is to look for catastrophic but hidden corporate situations. Accounting fraud is probably the most common one — and it’s probably the one that has the strongest immediate impact on the stock, but there may be other types too.”
Grego’s view highlights that although short sellers and ESG investors might casually be thought of as coming from opposite ends of the spectrum, in fact they have many similarities.
Most ESG investors only take long positions. But, just like short sellers, their raison d'être is to detect things that can affect a company’s value which conventional analysis of its financial statements does not pick up. And conversely, nearly all the allegations made by activist short sellers are actually ESG violations, because they involve the company having poor governance and concealing the truth.
Many short sellers are just as passionate in their anger at corporate abuses as the primmest church investor.
A particularly shocking part of US corporate life in recent years has been the opioid crisis. Deaths, ill health and addictions caused by legally prescribed painkillers have soared, and their manufacturers have continued churning out the drugs, sometimes seeming indifferent to the suffering they caused.
One such firm was Insys Therapeutics, maker of a sublingual fentanyl spray called Subsys. In 2014 and the years after, short sellers as well as The New York Times and investigative journalist Roddy Boyd detailed the relationship between Insys and the doctors who prescribed its incredibly powerful opioid, as well as Insys’ aggressive and corrupt sales tactics.
Some medical professionals were given lucrative speaking contracts and consultancy work with the firm. After years of legal battles, the firm filed for bankruptcy in 2019. Its CEO, John Kapoor, began a 5.5 year prison sentence for racketeering in January 2020.
For the short sellers who pursued Insys — including John Hempton of Bronte Capital — it was a battle of right against wrong.
The latest company in Grego’s crosshairs is Penumbra, a medical devices firm in California listed on the New York Stock Exchange with a $7bn market cap. Grego released a report on November 10 entitled: Penumbra and its ‘killer catheter’: A tale of corporate greed and seemingly blatant disregard for patients’ lives. It argued that Penumbra hurried a new product to market, to keep up with competitors and halt the dwindling of Penumbra’s market share. It was a catheter for stroke victims called the Jet 7 Xtra Flex.
Grego claims a malfunction in the new catheter has resulted in at least 18 deaths, an allegation also levelled by Roddy Boyd in the Foundation for Financial Journalism in September. Grego believes that Penumbra knew there was a problem with its device, but chose not to fully inform doctors of the risks for fear it would have to be recalled.
“When you’re in the business of medical devices, it’s a statistical fact that every once in a while you’ll bring something to market which doesn’t work and which can unfortunately kill and injure people,” said Grego. “But we have evidence to suggest that management was aware of the problem early on.”
Penumbra has called Grego “sleazy” and his attacks “inaccurate”, “misleading” and “baseless”. It said in a statement on December 8 that Penumbra “stands by the record of the Penumbra Jet 7 Xtra Flex”, that it “has helped thousands of sick patients”, and that it “is unaware of a single patient death associated with the use of Jet 7 Xtra Flex when it is used in line with the instructions for use and the notice Penumbra has provided to physicians.”
The company argued that Grego was trying to manipulate its share price with false allegations.
All mixed up
You do not need to care about ESG to realise that if Grego’s claims about Penumbra are true, it could be a serious problem for the company. For investors in medical companies, patient safety is not a peripheral, nice-to-have topic — it is the central and critical factor.
Even so, Grego admits that when someone first told him about this problem at Penumbra, he thought the proposition was not for him. But after taking a look he saw a few things, like what he believes are the company’s misleading claims, that drew him in.
Though Grego puts ethical considerations front and centre in his campaign against Penumbra, the short can be justified without recourse to morality. Grego believed the new version of the Jet 7 was likely to be forbidden by the regulators, which would have a profound impact on Penumbra’s revenues, and that Penumbra would face class action lawsuits from those who have suffered from the device.
The story shows how, for both ESG investors and short sellers, moral and financial issues are deeply intertwined.
The two disciplines also both face the same issue — they need to find things that are beyond the field of view of mainstream investors, but which will be visible to them in future. The difference is that activist short sellers are much less patient — they do not wait for the rest of the market to notice something, they shout about it.
Lives at stake
Sometimes, short sellers strip off their day clothes of financial investors and reveal themselves in superhero costume, as avenging angels.
Grego has company in his campaign against Penumbra. He is supported by Marc Cohodes, a veteran short seller in California.
Cohodes sets out a moral scale for short sellers themselves. “A lot of short reports focus more on the price of the stock and moving it rather than what the company does,” he said. “This company... their product should not be on the market. The management should be held responsible. This is the key to activist short selling. Not a stock’s too high, or some stupid story about rolling a truck down down a hill. This has killed and injured a lot of people, and it’s going to kill and injure a whole lot more people if someone doesn’t do something.”
Penumbra’s share price has not followed a similar trajectory to those of other companies targeted by Grego. In the first three days after his report came out, the shares went up 12.5%, to a record high. They then began a slow if uneven 18% decline over the next few weeks.
Market reactions are often unpredictable, which is testing for a short seller. While long investors can only lose the money they have invested, short sellers can lose far more if the share price rises against them for a sustained period.
Cohodes told GlobalCapital he had little interest in the tos and fros of the share price. “The stock price has zero to do with anything,” Cohodes said. “It will take care of itself. The market is frothy and this is not about stock price, this is about right and wrong. I’m outraged by this crap.”
On December 8, Grego released a second report, after which the shares fell another 15% in a week. This time, Grego alleged that “Antik Bose”, an academic researcher who had written complimentary reports on Penumbra, was a fictitious character likely to have been invented by Penumbra’s co-founder, Arani Bose. Grego argues that Penumbra may have committed securities fraud by marketing research papers by “Antik Bose” in its IPO documentation.
Penumbra responded later on that day, and said that “A. Bose” was in fact always Arani Bose, not Antik. It said anyone implying that Arani Bose’s “peer-reviewed research, co-authored with a large cohort of his peers, was ever or would ever be attributed to anyone other than Dr Arani Bose is inaccurate and conspiratorial.”
A week later, the story took a new turn. After the market closed on December 15, Penumbra announced that it was voluntarily recalling the Jet 7 Xtra Flex, “because the catheter may become susceptible to distal tip damage during use. Distal tip damage in conjunction with pressurization or contrast injection may result in potential vessel damage, and subsequent patient injury or death.”
The US Food and Drug Administration said it had requested Penumbra to voluntarily recall the catheter.
Penumbra’s share price fell 7% the following day, bringing it to 28% below where it had been before Grego's first report.
Target the enablers
Block, like Cohodes, is a short seller prone to righteous anger. So furious is he that capital markets support immoral corporate behaviour, he thinks short sellers should target, not just bad companies, but the enablers surrounding them: analysts who maintain buy ratings, auditors, banks, and investors who prop up their value.
“We in the capital markets are the lifeblood of this [immorality],” said Block, in a lecture at a Kase Learning conference a few years ago. “There are numerous people who inadvertently enable this… and as activist short sellers there’s an opportunity to turn that around and stop some of these runaway trains.”
Block argues that once a short seller has released a report detailing immorality, going after market participants who carry on supporting the company is fair game.
Once they have been informed, Block said: “They have a moral obligation at that point to really think about whether they should continue to own the stock, support the stock and contribute to the economic incentive to do these [immoral] things.”
Outing analysts and investors is not to humiliate them, Block says, but to publicise the fact that they have been given information about the immorality of a company, and chosen to ignore it.
“When I really thought about overt morality shorts, I considered the financial enablers around the company and I thought — you are contributing to that,” he said. “You are doing nothing to eliminate the financial incentive management has for this conduct. You are complicit — you have blood on your hands.”
Block said he had hoped this sort of targeting would happen this year, and that, had it not been for coronavirus, it might well have done.
Block would even go as far as geo-targeting an “enabler” at his or her workplace or home.
“You can get creative — you can take ads outside their building,” he said. “If [a campaign is] well executed you can put this person on trial at their dinner table with their family around, who will ask ‘is it true about what this company is doing?’ You have to make them explain it to their kid,” said Block. “None of us are Elliott Management. We have to operate like guerilla warriors.”
Trial by short seller?
By and large, short sellers personify everything the City reviles. They rarely went to the best universities and have no interest in becoming members of a financial fraternity. Happy warriors, they are often irascible and lack social niceties.
But they possess a monomania that can be extremely effective in rooting out fraud. One prominent short seller, Fraser Perring of Viceroy Research, reckons he spends well over 1,100 hours on a company before he feels confident to release a report. It only takes “40 hours to know the fraud exists to warrant an investigation, the rest of the time to stack it up,” he said.
Activist short sellers may also be filling a space left vacant by other guardians against corporate malfeasance.
Declining advertising and sales have blunted the teeth of the press, while in high profile frauds like Carillion, Folli Follie and Wirecard, auditors have been found wanting. With the scant resources they are allotted, regulators struggle to subject companies to the necessary scrutiny.
This perceived inadequacy of conventional checks has coincided with an increase in cash in financial markets. Central banks in Europe and the US have pumped money into bond markets, giving companies easy access to cheap money — which is dangerous.
Some argue that when cash is easy to come by, fraud is more likely. Investors look feverishly for opportunities to make money and take more risks. In their haste, they may be more lenient on a company’s financial statements, the argument goes.
The new boom market of ESG and ethical investing may be a bit like that — a craze in which niceties get missed.
As this large new audience for ESG stories emerges, short sellers are certain to try and spin yarns that will appeal to it. The shorters will also learn from their new market, and look in new places.
It could be a fruitful partnership. Short sellers — armed and morally indignant — are ideally suited to be the shock troops of the ESG movement.
But someone needs to keep an eye on them, too.
Short sellers see themselves as the perfect free market corrective — the market sorting out the market, without costing the taxpayer a penny. But some have been wrong about companies before, and they have a clear incentive to exaggerate their criticisms. Some might worry that ‘trial by short seller’ itself lacks the necessary ethical dimension.
Boohoo was approached by GlobalCapital for comment. Penumbra referred GlobalCapital to its prior public statements on Quintessential Capital.