Hyenas play a vital role in financial markets, too

Wild animals resemble the financial markets with professional short sellers cashing in, but the health of the market ecosystem needs them

PUBLISHED : Tuesday, 18 September, 2012, 12:00am
UPDATED : Tuesday, 18 September, 2012, 3:45am

There are many animals that people find repulsive which actually play a vital role in sustaining their ecosystems.

Take hyenas: reviled for feeding on carrion that even vultures leave behind, these grotesque creatures (the female spotted hyena even sports an organ known as a pseudo-penis in place of more conventional genitals) support many far more picturesque species.

With their massive jaws that allow them to crunch up and swallow even the heaviest animal bones, hyenas provide an essential source of calcium, without which the birds and tortoises that eat their dung would never be able to form the egg shells of their young.

In that way financial markets have a lot in common with natural ecosystems. Even participants who get a lot of criticism for sharp practice often perform an essential service for more respectable market players.

Professional short sellers are a prime example. Over the last year or so a handful of fund managers have hit the headlines for publishing allegations of fraud and false accounting by Chinese companies listed in the United States and Hong Kong.

On publication the companies' stock prices usually nosedive, generating handsome profits from short positions the fund managers have previously amassed in their shares.

The returns can be substantial. On average targeted stocks fall by around 20 per cent on the first day following the publication of a short-seller's report, even if the allegations subsequently prove dubious and the stocks go on to rebound.

In the last year or so the short-sellers have scored some clear hits, notably with Muddy Waters' report on Sino Forest. The Toronto-listed timber company was subsequently de-listed after filing for bankruptcy protection (see the first chart).

In other cases investors have given targeted companies the benefit of the doubt. Shares in Chinese semiconductor maker Spreadtrum, for example, have now climbed 52 per cent since Muddy Waters published a negative report on the company in June last year.

Some of the targeted companies have attempted to fight back, denying all allegations and accusing the shorts of earning dishonest profits by peddling malicious and damaging lies.

Their success has been mixed. In August 2011, Silvercorp Metals, a Chinese mining company listed on the New York Stock Exchange, found itself under attack. A short-seller called Anthion Management circulated a report accusing Silvercorp of exaggerating the quality of its ore deposits, understating its production costs, and fraudulently inflating its cash holdings.

Over the next couple of weeks as further allegations surfaced questioning the authenticity of Silvercorp's customers and the viability of its acquisitions, the company's share price plunged 20 per cent (see the second chart).

In response Silvercorp denied the allegations, commissioned a report from accountancy firm KPMG which supported its denial, and filed a New York lawsuit accusing Anthion of defamation, trade libel, unjust enrichment and "unlawful deceptive acts and practices".

The judge, however, had little sympathy with Silvercorp's complaint. In a 29-page disposition last month, she ruled that because Anthion made its own interest plain, and because it made clear its conclusions were its own interpretation of Silvercorp's disclosed statements, the short-seller's allegations were "nothing more than a matter of personal opinion"" which is protected by law, and did not constitute either defamation or libel.

Similarly, the judge ruled that because Silvercorp had never paid Anthion for any services, the claim of unjust enrichment could not apply, and that because no consumers were disadvantaged, Anthion's allegations did not amount to "deceptive acts or practices". As a result, Silvercorp's suit was dismissed.

The miner has appealed, but even so the judge's ruling sends an important signal. It serves companies with notice that if they want to protect themselves against short sellers, they cannot rely on the courts. Instead they will have to persuade shareholders that they really are a sound investment.

And the only way they can do that is by raising their governance standards and improving their disclosure. There is some evidence this is already happening.

According to a recent analysis by brokerage house CLSA, short sellers are finding it increasingly difficult to make big profits by targeting Chinese corporations implying that company managers have responded to the attacks by raising their game.

If that's true, then it seems short sellers do play an important role in policing company managers and ensuring they stay honest.

As far as ordinary investors are concerned, these hyenas are essential to the health of the market ecosystem.