Stock short sellers, so-called short sellers, are often a healthy corrective in financial markets. They contributed to the accounting scandal surrounding the ex-DAX group Wirecard being exposed. But sometimes they are wrong in their assessments.
Deminor Senior Legal Counsel Patrick Rode shows the work of short sellers using four examples.
This analysis was first published on Das Investment on 30/04/2024
Short sellers play an important, albeit often controversial, role in the field of investments. Short selling is an investment strategy in which investors speculate on the decline of a share price. Short sellers place bets on the decrease in the price of a security and profit financially if the share price actually collapses and the bet materialises. While traders therefore use short selling as a speculative tool, investors or portfolio managers can also use short selling to hedge against the downside risk of an investment.
The practice of short-selling can have a significant impact on the companies concerned and their share prices. It is particularly controversial when - as has been observed several times in recent years - the short sellers themselves influence share prices by publishing their own research to such an extent that they benefit considerably from it. In addition to the positive examples of Wirecard and Steinhoff, Spain-based Grifols and the Swiss company Temenos have also been targeted by short sellers, in each case with different results.
Steinhoff N.V. and Wirecard: Short sellers as a corrective on the capital market
Steinhoff was a Dutch multinational holding company with a dual listing on the Frankfurt and Johannesburg stock exchanges. Over the course of five decades, Steinhoff grew from a small German furniture company into Europe's second-largest multi-brand retailer of home textiles. Steinhoff was a great success story - until early December 2017, when the company suddenly informed the market that its financial statements would only be published in unaudited form due to "certain matters and circumstances" requiring further review, including an independent investigation into possible accounting irregularities. While the company remained (intentionally) vague in its public communications and ultimately never released the report of its internal investigation, the publication of a report by short seller Viceroy Research LLC a few days later shed much more light on the matter. It convincingly revealed the artificial inflation of net profit, undisclosed transactions with third parties and other worrying findings. Steinhoff's share price plummeted as a result and Steinhoff was sued by its shareholders. This lawsuit resulted in the second largest settlement in a shareholder lawsuit outside the US in 2021, totalling EUR 880 million.
Wirecard provides a very impressive example of how dramatic the effects of short-selling can be. For many years, Wirecard enjoyed impressive growth and was even included in the DAX. Over time, the company's balance sheets were increasingly called into question. Short sellers, including the British research company ShadowFall or the American investor Muddy Waters, played a crucial role in uncovering discrepancies and ultimately fraudulent accounting practices at Wirecard. Their reports and analyses, supported by research by investigative journalists, in particular the Financial Times, contributed to Wirecard's share price collapsing when the fraud allegations turned out to be true. This case thus shows how short-sellers can contribute to improved market transparency by acting as a corrective to market exaggeration and manipulation.
Grifols SA: Allegations not entirely accurate
Grifols, a leading company in the field of biotherapeutics and known in particular for its plasma products, was also targeted by short sellers. The company, which expanded rapidly through numerous acquisitions, faced scepticism regarding its high debt burden and the sustainability of its growth. For example, Gotham City Research published a 65-page report at the beginning of January 2024 claiming, among other things, that Grifols had understated its reported debt by almost EUR 1 billion and significantly overstated its EBITDA. The share price lost up to almost 40% of its value following these allegations and has not recovered significantly since then, despite reassuring statements from the company management and discussions with investors. The Spanish supervisory authority ("CNMV") has asked Grifols to explain various aspects of its accounting and has also carried out an audit itself.
Although the CNMV initially stated that it had found "no material errors" in the amounts reported by Grifols, it considered the accounting treatment of several items reported in Grifols' reports for 2021 and 2022 to be "inappropriate". In addition, the CNMV also identified other relevant deficiencies in various areas. The supervisory authority concludes: "These deficiencies, although difficult to assess individually and separately, must be considered significant as a whole, as they have prevented investors from adequately understanding the issuer's financial position, results and cash flows over several years".
The CNMV investigation and Grifols' clarifications have helped to understand a little better what is really going on, but it seems that the market still has doubts about the financial reality of the company, as the share price has not recovered to the level prior to the publication of the Gotham report in January. In addition, cannot rule out the possibility that Gotham is preparing another report on Grifols Another report published by the short seller on 6 March 2024 was entitled "Grifols SA: How an advance payment becomes a loan Part I". The impact of a possible Part II of the report remains to be seen.
Temenos AG: Research by short seller may prove to be unfounded
Temenos is a Swiss-listed company that develops banking software and offers services, serves 3,000 customers worldwide and reported revenue of USD 1 billion for the 2023 financial year. In mid-February 2024, Hindenburg Research, also a short seller, published a report that addressed, among other things, accounting irregularities and misrepresentations to investors by Temenos. The report alleged that Temenos manipulated sales, artificially inflated profits, misrepresented research and development spending, backdated contracts and failed to properly disclose cancelled projects in a timely manner. Temenos executives are also accused of insider trading. The share price fell by almost 35% that day. However, the company denied all allegations and commissioned an independent investigation. This was published two months later together with the annual report for 2023. This investigation concluded that the allegations made by Hindenburg were inaccurate, misleading or out of context, and that Temenos' practices were largely in line with standard industry procedures and regulations. As a result, Temenos' share price recovered quite significantly. What was particularly controversial in this case was that Hindenburg Research based its findings primarily on former Temenos employees, but did not name them further, so that it was not readily possible for third parties to verify these claims.
Regulatory measures to control and future challenges of short-selling
In the past, cases such as Grifols and Temenos have led to an increased discussion about the need for stricter regulatory measures for short selling. Regulation aims to create transparency and prevent abusive practices without preventing the positive aspects of short selling. In the European Union, for example, short sellers must disclose their positions as soon as they exceed a certain threshold. These transparency regulations are intended to enable investors and supervisory authorities to recognise and assess unusual market activities more quickly.
In the USA, short sellers are monitored by Securities and Exchange Commission (SEC) regulations, which include similar disclosure requirements. These rules are designed to ensure sufficient market liquidity and minimise the potential for market manipulation. In addition, there are specific regulations such as the "uptick rule", which requires that short selling may only take place at a price that is higher than the last traded price in order to alleviate downward pressure on share prices during volatile market phases.
The future of short selling faces a number of other challenges. On the one hand, the digitalisation of financial markets is increasing the speed and volume of trading activity, making it more difficult to monitor and manage risk. Secondly, the increasing popularity of alternative investment strategies and financial instruments using artificial intelligence and algorithmic trading could further change short-selling.
Technology is expected to continue to play a key role for both short sellers and regulators. Advances in data analytics and artificial intelligence could make it possible to analyse market data faster and more accurately, which could increase the efficiency of short selling while reducing the potential for fraud and abuse.
Conclusion
Short sellers can play an important role in the financial system by contributing to market efficiency and transparency. The above examples clearly show that short-selling is far more than just a speculative investment strategy. It has the potential to expose fundamental weaknesses in companies and contributes to healthy scepticism and critical analysis in the financial markets. At the same time, these cases emphasise the need for regulated and transparent execution of short-selling practices in order to avoid abuse and strengthen confidence in the markets.
The Wirecard case has shown the potential benefits. The involvement of short sellers can be an opportunity for companies, prompting them to critically review and adapt their business models and balance sheet structures. However, examples such as Grifols and Temenos also highlight the risks and the need for careful monitoring and regulation of this activity.
Regulatory adjustments and technological advances are having a decisive impact on the practice of short selling. Corresponding developments are essential to ensure the integrity of the markets and protect investor confidence. At the same time, it is important that regulation remains flexible enough not to hinder innovative and legitimate trading strategies and to ensure balanced and effective market regulation.
