Why integrity bolsters protection against malicious short-sellers

Potential threat of illicit short-selling needs to be high on a listed company’s agenda. Preparation is vital to overcome such incidents.

In brief

• Short-selling occurrences are on the rise as market volatility entices bad actors to find ways to manipulate company share prices for their own benefit.
• While regulators are beginning to look more closely at this trend, few proven strategies exist once a company has been disrupted by short sellers.
• Short sellers who conduct objective research and act based on their findings provide value and promote market transparency and scrutiny.

The prevalence of short-selling disruptions has increased dramatically over the past 24 months. Market uncertainty driven by both the COVID-19 pandemic and financial reporting seasons has created fertile ground for short sellers to impact a company’s share price. The expectation of volatility creates an opening for bad actors wishing to manipulate share prices for their own gain, as market followers often assume it’s just more of the same erratic behavior they’ve already been witnessing. Legitimate short sellers and/or hedge funds who have done their research and are making moves in the interest of market transparency serve a valuable purpose. Their behavior is well-conceived, not erratic. They keep companies honest and through their actions, play an important role in facilitating legitimate scrutiny about what’s happening in the market. Conversely, short sellers who take actions based on invalid or fictitious claims in the interest of making a profit for themselves fuel market skepticism and can cause considerable damage to the reputations of the companies they target.

One of the factors behind this trend is the relative lack of consequence for being a dishonest short seller. Listed companies are obligated to make certain financial disclosures and go to great lengths to validate this data. A short seller intent on causing harm is not bound by ethical standards. They can say whatever they want and due to the lack of strong enforcement measures, they are emboldened to launch even more attempts, make more money and have a greater impact manipulating the market in their favor.

Regulators are beginning to take notice of the rise in short-selling attacks. However, for now, the burden is on companies to be aware of the threat and develop their own response strategy. Fortunately, there are ways to mitigate the risk of becoming the next victim.

Scrutinize every disclosure

There is data and information available everywhere that is obviously at the fingertips of investors and short sellers. The more data that companies put out there, the greater the platform to find an issue, the easier it becomes to set up and execute short-sellings. A critical first step in protection is proactively and regularly reviewing the quality and reliability of the information that is being disclosed. Listed companies need to ensure that both financial and nonfinancial information is current, accurate and updated in real time. Pay particular attention to financial statements, data about the length of tenure for executives at the company and the geographical footprint of officers throughout the organization. Inaccuracy in any of these areas can open the door to those seeking to do harm.

Secondly, monitor requests and questions that come into the business from the investor community. Look for particular areas of focus that are being probed or specific pieces of information that are being extracted in which there is a high level of security or potential risk.

When it comes to disclosures, be proactive in challenging the transparency of the reporting and then cross-checking to ensure it is in line with market expectations and understanding. Take the time to understand and explain the disclosures and be clear about the distinction between cash flows within the financial statement.

Finally, follow industry trends and be aware of other entities that may be coming under scrutiny, or where other industries are being challenged. Stay ahead of the curve in terms of expectations and scrutiny, which will put management in a better position to be able to respond and provide valuable transparency.

The key to each of these steps, of course, is discipline. Companies need to be aware at all times of what’s happening, what’s being disclosed and how it could all impact the business. All it takes is one lapse in effort to create a significant problem.

Be aware of all the risks

While no one is immune to short-selling, certain industries are more susceptible than others. For example, a technology company whose financial results can significantly shift one way or another based on how accounting standards are applied to the business. Short sellers can go from company to company in the same industry that would be expected to have similar issues.

Another risk is historical or reputational concerns at an individual level. If short sellers can identify a problem, they can follow that individual to a company and try to discredit them based on past events or indiscretions that might have been disclosed. High-performing stocks with a significant growth rate are also prone to being targeted. The greater the return, the greater the growth, the greater the scrutiny. Short sellers can look for what’s driving the growth and question whether or not it’s too good to be true.

Companies can help protect their interests by building trust and transparency with regulators and stakeholders, and by establishing a foundation of good governance and corporate integrity within their organization. A record 97% of respondents to the EY Global Integrity Report 2022 agree that integrity is important. However, the report reveals that senior management is often overconfident in the effectiveness of its corporate integrity programs.

Creating an optimal integrity environment is a whole-enterprise environment, in which values are shared across every level of seniority and function and there is a high degree of transparency and zero tolerance of transgression. As mentioned, regulators are taking notice of the problem of short-selling. The more a company can do to manage its own operations with integrity and transparency, the more prepared it will be to deal with challenges as they arise.

Prepare for disruption before it happens

Legal challenges, jurisdictional complexities and cost often make it difficult for organizations to have recourse against short sellers, so being prepared in advance of an attack is crucial. Assemble a cross-management plan and triage who within the company will deal with the immediate response. This isn’t something that can be handled through the normal course of business. Senior management teams and boards need to proactively strategize on how to best defend themselves. Companies need a team focused on responding to the short-selling occurrence, one that has already developed a detailed strategy.

If the worst should occur, there will obviously be heavy reliance on the company’s auditors. But other advisors will be needed to independently prepare and scrutinize responses to assist the management team in responding to the market. Legal advisors, either internal or external, will also be needed to help navigate the decisions that need to be made from a continuous disclosure perspective and a market reporting perspective.

Another part of the response plan would be to get an unbiased view of the issue that has been raised to determine what is fact and what is fiction. If the short seller has raised issues that are not credible or are unsubstantiated, and the strategy is to go to market, report the truth and provide relevant context, that could be a positive development. Management needs to be sure, however, to ensure decisions are based on reality rather than speculation.

Here are some practical steps that should be considered when strategizing against a potential short seller intrusion:

1. Assess

Review industry trends, financial intelligence and potential risk areas.

2. Prepare

Using industry trends, develop a response strategy (pre and post) for a potential short selling attack, focusing on identified risk areas, in the same manner you would prepare for a potential cyberattack.

3. Pay attention

Be aware of the indicators mentioned and how those change over time. Your policy and response should be a dynamic document that responds to these changes.

4. Monitor

Continually monitor market sentiment and opinion of your organization.

5. Consult

Consider engaging a third party to provide an independent assessment of key risk areas, and/or the preparation and coordination of responses.

6. Engage

Select the right team of external advisors and engage them early in the process.

It’s also worth noting that some companies consider whether or not to respond to a short seller occurrence. There are observable examples that responding too quickly, or responding at all, is simply fueling the expectation of the market. In other cases, it only serves to spook the market by not providing greater certainty. It may also provide the short seller more information on which to action. No short-selling occurrence has the same impact on a company.

Often with unsophisticated short sellers or hedge funds, reports are so ambiguous and poorly presented that responding is too risky because the underlying issue may not be fully explained, may not be based in reality, or may not be supported by the underlying disclosures of the company. In this instance, riding out the issue is probably a better way to go.