Short Sellers: Market Traitors or Balance Keepers?
When stocks rally and make upward price jumps, most investors are ecstatic and marvel at their recent gains. The thing they fear most is the inverse: large price declines or corrections, which wipe away their unrealized profits. While this depiction holds true for the vast majority of stock traders, a select few choose to bet the opposite way – short sellers. These investors actively bet against stocks or the general market. Instead of making gains through an increase in the value of their holdings, they “short” stocks and profit from their downfalls.
The mechanics of different types of short trades can be complex depending on the asset class and terms of the trades. However, the most common method of shorting a stock is relatively simple to understand. A trader who believes the price of a stock will go down makes a short trade by borrowing shares from another person who holds the given security. They immediately sell the borrowed shares at what they believe to be a high price, and once the price has dropped, they repurchase the shares to “cover” and return them to their owner. During the time period they are holding the short position, they are responsible for paying out any dividends the initial holder might have received, as well as interest embedded in most contracts to incentivize the agreement in the first place. Finally, the borrower must also hold sufficient collateral in their account to protect the person lending shares against potential losses Unlike long positions, where the greatest loss someone can suffer is the equity they initially put in, the downside risk for short positions is infinite since the price can continue to rise indefinitely.
Many successful short positions have vaulted traders into the spotlight and earned them a permanent legacy. Fahmi Quadir made a name for herself when she successfully shorted Valeant Pharmaceuticals, a company whose stock had been skyrocketing through an aggressive M&A strategy. The company had the backing of Bill Ackman, and Quadir’s position was certainly contrarian. As shown in an episode of Netflix’s Dirty Money, Valeant was eventually exposed for fraudulent practices and their stock dropped immensely. Creative short positions in different asset classes have also proved to be profitable, and at times controversial. George Soros took away over a billion dollars by shorting the British Pound, betting that the central bank would not be able to maintain its currency exchange rate. More recently, Bill Ackman made the “Greatest Trade of All Time” by shorting corporate bonds using credit default swaps, and taking home $2.6 billion profit for his firm, Pershing Square. Notwithstanding the risk, successful short positions can result in massive payouts and legendary status.
Short sellers as a whole have earned somewhat of a negative reputation since they tend to profit while other investors struggle. In certain cases, some have argued that short positions push down companies who otherwise would have prevailed, and thus taking short positions is almost unethical. Many questionable, and sometimes illegal, shorting tactics have likely led to short selling being characterized as a cynical and dirty practice. So-called “bear raids” take place when groups of investors gang up on a company, forcing downward pressure on the share price using short sales. Since companies use capital markets to raise money, a depressed stock price can cause them to tighten their spending, propelling a downward cycle. While this is a simplification of the situation, the potential ramifications are significant. Some reporters and financial analysts partially attribute the fall of Bear Stearns and Lehman Brothers during the ’08 financial crisis to the intense pressure of short sellers’ bear raids. To exert this pressure, short sellers have also used a tactic known as naked short selling, a now illegal method of shorting a company’s shares without ever borrowing any of them.
As previously described, a short seller usually borrows shares to sell, and then buys them back later at a lower price to realize their profit. In a naked short sale, the trader never borrows shares at all. Instead, they agree to sell shares to someone without first owning them. Since there is a three day “settlement period” to deliver the shares to the purchaser after the agreement, the short seller is simply hoping that the share price will fall over that short-time frame. If it does, they can purchase the shares quickly at the lower market price and deliver them in the time window to receive a higher agreed upon price. However, if the price does not fall, the trade will likely result in a failure to deliver. This tactic has been outlawed in many jurisdictions as the short seller enters the agreement unfaithfully since they do not own any shares at the time. It can also create artificial downward selling pressure on a stock, even though the sale may never be realized. These shady strategies clearly have little economic value and give a bad name to short sellers.
On the other hand, short selling can be part of the natural balance of the market. If a stock is overhyped or has an inflated valuation, short pressure can force investors to keep their wits about them and maintain efficient pricing. Even more importantly, many contemporary activist short sellers seek out fraudulent or unethical business practices and expose them to the world. While many investors are simply looking for the good in a company, short sellers do the opposite. Oftentimes they find what many have overlooked and prevent substandard companies from benefiting from the capital markets. Citron Research, a prevalent activist short-selling firm, released a public report detailing the malfeasances of Valeant Pharmaceuticals which played a crucial role in exposing their practices and leading to the downfall of the company. More recently, another activist short-selling firm Hindenburg Research released an extensive report on electric vehicle maker Nikola, detailing allegations of fraud and false claims. The report included a confirmed claim that an electric truck driving in Nikola’s promotional video had not been driving at all but was simply rolling down a slight hill in neutral. Clearly, research and reports of these kinds have real value to the public, even if the short sellers are the ones who end up profiting from prices declining.
Ultimately, regulators possess the ability to draw the line between short selling which adds value and dishonest tactics which purposefully squander firms’ abilities to succeed. The SEC has changed their approach to short selling over the years, using various methods in attempts to stop the unwanted consequences of rampant shorts. They attempted to use an “Uptick Rule”, which only allowed shorts on a stock that had increased in price from their previous sale. After almost 70 years, the rule was repealed in 2007, as research showed it was ineffective and caused market distortions. The timing of the repeal allowed pervasive short selling to take place during the financial crisis in 2008, and the rule was eventually modified to a new version which was enacted in 2010. The SEC has also taken steps such as outlawing naked short sales and even outright banning shorting temporarily in times of crisis.
The game of cat and mouse between regulators and abusive short practices will likely never end, but Canada may be behind the curve. Canadian regulators have taken a more hands-off approach, leaving companies and investors vulnerable to questionable tactics which have been outlawed elsewhere. Under current rules, naked shorting remains viable in Canada, and many have called into question whether regulations should tighten. Canadian companies have also become targets for American short traders, with weak or non-existent disclosure rules and easier manipulation. To avoid the consequences of abusive practices, Canadian regulators may have to ramp up their efforts and attempt to get ahead of short sellers who bend the rules in their favour, at the expense of economic efficiency and ethical investors.