60 Minutes recently profiled what it called a conspiracy of hedge funds and stock research analysts to drive down the stock price of a Canadian drug company called Biovail. Joe Nocera of the New York Times did an admirable job of debunking this story and clarifying how markets actually work, versus the impression that markets are corruptly manipulated by “secretive,” “unregulated” hedge funds. The alleged participants in this conspiracy are SAC Capital Advisors, an $8 billion hedge fund, and Gradient Analytics, the independent research firm that specializes in accounting research.
60 Minutes is implicitly saying that you should be able to analyze and discover accounting irregularities at a company, but you should not be able to profit from that discovery by informing the news media, shareholders, and the broader market. If you wish to make a profit by shorting the shares (selling borrowed shares) of badly managed companies, you are a greedy stock manipulator and the government should punish you.
Many journalists, politicians, and regulators fear short selling. They fail to see that short selling plays a critical role in offsetting irrational exuberance, checking the accuracy of financial statements, and rooting out fraud. In addition, they don’t understand that stocks and the overall market are actually strengthened when the shares sold short must eventually be “covered,” or bought back. The practice of buying back shares at a lower level is a vital market mechanism for digesting negative information in an orderly manner. Short sellers enable stock prices to quickly adjust to levels that better reflect intrinsic values, thereby preventing crashes and panic selling.
Nocera’s comments (“Selling Short the Virtues of Short Sellers,” April 1) are excerpted below:
Mainly, [60 Minutes' Leslie Stahl] seemed shocked that people on Wall Street actually wanted stocks to go down. “This is a story about a large company accusing another large company of trying to drive down its stock price to make money,” she began, in a tone that suggested that was the sort of thing only bad people did. As her story developed, she had a handful of Gradient whistle-blowers asserting that the firm’s analysts took notes about all the “dirt” SAC had dug up on Biovail, and then repeated that dirt, word for word, in its reports. She noted that at the time Gradient was issuing a report that is at the center of the case, most Wall Street analysts were positive on the company. (Imagine that!) She swallowed whole the implausible notion that Gradient’s reports were directly responsible for the drop in Biovail’s stock price â€” never mind the company’s earnings shortfalls and other problemsâ€¦
The silliest idea embedded in both the Biovail lawsuit and the “60 Minutes” segment is that because an analyst, a short seller, a research firm, and even a reporter are talking with one another â€” and perhaps even collaborating â€” that they are somehow engaged in stock manipulation. This is what people do in markets all the time, on the long and short sides. When you have a big position in a stock, you want to persuade others to your point of view. You make your case in phone calls, or at conferences, or over drinks. You try to get reporters to write articles reflecting your views. If you can get others to agree with you, and either buy or sell because they are persuaded by your logic, that is good for both you and the market.
In some ways, the process is even more important for a short seller because his point of view is invariably a minority one. In early 2001, when the short seller James Chanos became convinced that there was something amiss at Enron, he didn’t keep that information to himself. He spoke to Bethany McLean, the Fortune reporter who then wrote her famous story, “Is Enron Overpriced?” And he presented his views about Enron at his annual Bears in Hibernation conference. One of those attending was Mark Roberts, a newsletter writer who then wrote a tough report on Enron. According to a witness in the Enron trial, that is the report that caused Jeffrey K. Skilling, the chief executive, to exclaim, “They’re on to us.”
Did Mr. Chanos have a short position in Enron? Of course he did. Was he hoping that as word spread, the stock would go down and he would make money? Sure he was. Was it a bad thing that Mr. Chanos was telling anyone who would listen that Enron was a house of cards? You tell me.
Under the Biovail standard, Mr. Chanos wrote in a recent e-mail message, “Enron could have sued me for talking to Bethany McLean and Mark Roberts for writing up my bear case on Enron.” He added, “If stock prices go down, are we suspending the free speech provisions of the U.S. Constitution for market skeptics and short sellers?” Actually, this appears to be already happening. From what I can tell, Mr. Chanos is the only short seller in the country still willing to talk to reporters on the record.
Will short information always be as prescient as the Chanos call on Enron? Of course not. Again, though, how often does the long side get something wrong? That’s the whole point about stocks â€” some people believe that they’re headed up, and others that they are going to fall. If you don’t have that debate, you don’t have a marketâ€¦
I’m skeptical about the Biovail accusations. History suggests that most of the time, when a company lashes out at a short seller, it is because it really does have something to hide. Companies that beat back short sellers do so not by suing them but by running the business so well that the shorts are proved wrong. As Mark Cuban, the billionaire owner of the Dallas Mavericks basketball team, put it on his blog recently, good C.E.O.’s know that “a great operating company will make the shorts cover and push the stock higher.” And bad C.E.O.’s think, “if I can create a diversion, I know I can convince at least a few funds to hold on, and that gives me a chance to sell more stock.”
As I watched Ms. Stahl on Sunday, I kept thinking about AremisSoft. In the summer of 2001, AremisSoft, a software company, filed a lawsuit making many of the same accusations Biovail is making against Gradient and SAC. It accused the short-selling firm Rocker Partners, the journalist Herb Greenberg and a handful of Wall Street players of conspiring to drive down the company’s stock and “facilitate the profitable covering of short sales.”
A month after it filed the lawsuit, the company announced that it was being investigated by the Securities and Exchange Commission. In time, the company wound up settling serious fraud charges, and its former chief executive agreed to disgorge $200 million in “unlawful profits.” The shorts, and Mr. Greenberg, were vindicated.
Back when the battle was raging, AremisSoft’s biggest defender was Irwin L. Jacobs, the Minneapolis investor and former corporate raider, who had a large position in the stock. The other day I called Mr. Jacobs to ask about AremisSoft and those who were short the stock. His analysis was pretty simple. “The fact is that they were right,” he said. “Their homework was better than mine.” Mr. Jacobs added that he had subsequently called Rocker Partners and had apologized for his role in attacking the firm. “I looked like a fool when it was done,” he said.
Something to think about the next time you hear about a company suing its short-selling critics.