Shining a light on short selling

It is almost exactly a year ago that Steinhoff imploded spectacularly. While the market was still reeling, a previously unheard of research company called Viceroy emerged with a perfectly timed report that documented many of Steinhoff’s accounting shenanigans.

In January Viceroy followed up with a report that accused banking group Capitec of predatory lending practices and misstating its defaults. After Steinhoff, investors were easily spooked and the stock fell from R1 069.30 to R800.60 instantly (it has since recovered).

Rumours were soon swirling that the reports were leaked deliberately to drive the share prices down, to the benefit of shadowy short sellers whose identities remained hidden.

The discussion on short selling gathered pace in February when an internal report written on the Resilient Property Group by hedge fund manager 36One was leaked. The report suggested that management was artificially manipulating the share prices of its group companies. While management denies the allegations, the market is not convinced and the share price is yet to recover.

In the process, short selling, which is a stock tool used by hedge fund managers to mitigate risk, got a bad rap. Short selling involves the sale of shares that the seller does not own but has borrowed from a broker. Sellers take on these transactions because they believe a stock’s price is headed downward, and that if they sell the stock today, they’ll be able to buy it back at a lower price at some point in the future.

Thus it seems timeous that last week the Financial Sector Conduct Authority (FSCA) published proposals that aim to bring more transparency and regulation into the practice of short selling for comment.

“We believe that improving the transparency of short sale transactions will have distinct benefits that will outweigh any associated costs,” the document reads.

Greater disclosure will help deter market abuse and reduce the risks of disorderly markets posed by short sales. It could also provide early warning signs of a build-up of large short positions, thus alerting regulators to potentially abusive behaviour and enabling them to monitor and take action more effectively.

An FSCA spokesperson noted though that the regulator would prefer to keep a light hand when it comes to regulation. “While some aspects of short sales require regulation, short selling has an important role to play in the market: it contributes to efficient price discovery, increased market liquidity, and facilitates hedging and other risk management activities.”

The regulator envisages a two-tier system for the reporting and disclosure of significant short positions held in shares. The first is a requirement to alert the regulator (private disclosure) once a net short position has reached a specified trigger threshold (0.2% of issued shares has been proposed). If the short position then reaches a second, higher threshold, the obligation falls to the regulator to make a public disclosure to the market.

“These proposals, if applied, would bring South Africa in line with global standards,” says Jean-Pierre Verster, a portfolio manager at Fairtree Capital. “It’s about strengthening the corporate governance framework and that is not a bad thing.”

Verster runs both local and global long/short funds and has been exposed to the need for disclosure when buying European stocks, among others. He is comfortable with the concept of better disclosure and says short sellers do not need to hide behind a cloak of anonymity to do what they do. “While hedge fund managers do bet on a particular share price decline, it is not in hedge fund managers’ interest to artificially drive down prices. You need to understand that relative to the long-only market, short sellers are taking very small positions.”

He notes that others in the market, including those in companies that are the target of short-selling, may have to adjust to the idea. “There is nothing personal in a short-trade,” he says. “It is simply a risk mitigation strategy.”

The final date for submissions is January 15. From there FSCA will engage with the industry. No date or deadline has been set for the implementation of the proposed regulations.