OLD ARTICLE – Original posted on July 24, 2018
The American-styled short-selling model works on aggressive negative press releases, research and other PR stunts (now apparently including legions of anonymous Twitter accounts) to drive a share price down. Fair is fair, none of these actions are illegal if they disclose their beneficial interest.
While this business model is aggressive, it is probably not that different from some long-styled managers’ models of talking up their own shares. I, myself, post articles on this website about the companies that I like and am invested in. Like I said, fair is fair.
The only real difference is the trump card that the short-sellers hold: accusing the company of fraud.
In financial markets, you are guilty till proven innocent and (publicly & aggressively) accusing a company of fraud tends to emote strongly negative responses in its share price. These responses can make those holding shorts on its stock quite a handsome fee, but how true are these accusations? As usual, the devil is often in the detail and a little finanicial education can go a long way here.
In global financial markets, there are three things I can guarantee:
- Fraud will always exist somewhere and somehow: The stakes are too high and incentives built into human nature are too alluring for charlatans not to exploit. Lazy capital and gullible investors will always exist and someone somewhere will always exploit them. This is the same reason the lottery exists: greed, laziness & ignorance. Hence, fraud will always exist somewhere and somehow. And, typically, given enough time, fraud will always be exposed. There is only so long that a lie can be perpetuated when the underlying does not exist.
- Most listed companies are actually quite legitimate and are not riddled with major fraud: At absolute worst, most listed companies are quite mediocre with overpaid and underperforming Boards and management teams. Business is tough and corporate governance is often the first thing to be sidestepped, but that is not automatically the same thing as fraud. Bad businesses are sometimes just bad businesses. Bad management is sometimes just bad management. Not everything is fraud, despite what the perma-bears and pessimists preach.
- People will always act according to their incentives: Management teams will always act in a way that is most likely to get them paid. CEO’s that hold large tracts of their own script will always window-dress results to help their share price. Short-sellers will always scream foul on the shares that they are short of, irrespective of whether they are right or wrong. Investors will always follow those that promise them the highest return. People will always be biased and–sometimes intentionally, sometimes unintentionally–act to further their own self-interests. This does not make them good or bad, it just makes them rational, emotive human beings. Once again, if people act according to this but within the realms of the law, then this is not fraud.
Hence, I arrive at the question: what is fraud and what is not fraud?
I could launch into a whole bunch of definitions and legal jargon, but rather let me set out three scenarios. Only one of these scenarios is actually fraud, irrespective of what anyone (especially those with vested interests) calls something:
Bad business / bad management:
Business is hard and sometimes it fails. Being listed is expensive and complicated, and sometimes businesses underperform. Sometimes management sucks and they make bad decisions that cost shareholders dearly. Sometimes management pay themselves too much based on onerous contracts and weak/vested RemCo’s. Sometimes shareholder interests are not looked after.
All of these and more scenarios lead to bad results, poor share price performance and angry investors, but–assuming all the laws of the land are followed–they are not fraud.
They are just bad business and/or bad management, and their share prices will reflect this. As noted above, this is #2: bad business & bad management. That is all.
IFRS has rules on how to account for transactions. Not just are there many different rules with many different applications, but many of these rules require a degree of discretion on how to apply them.
For example, an asset that a company has bought can be accounted for in many ways. From mark-to-market fair valuing it to accounting for it on a depreciated cost. If the former is chosen, then a fair value has to found or calculated, which opens itself up to aggressive views. If the latter depreciation method is used, then management has to guess a useful life, a residual value and an approach to calculate the annual depreciation. All of these assumptions open up a company’s accounts to interpretation.
And then, don’t forget, a company can just expense the asset in the period in which it was acquired? As I said, plenty of different, legitimate ways to account for a single transaction.
What I am saying is that all of these rules and their related assumptions are open to interpretation by management. They will choose which method to apply, they will choose what assumptions to apply and then the external auditors will check the reasonableness of this. Hopefully, this final check by an external party is rigorous, but let’s be honest and accept that sometimes it is more of a tick-box.
Hence, sometimes a company’s results and its profits are not in fact entirely correct. Actually, a company’s financial results are never entirely correct. Rather every single set of financial accounts is a combination of guesses, estimates, and assumptions that operate as a negotiation between management, auditors and the market.
Now, after you get over that fact, you will accept that some companies account more aggressively than others. If they have followed all the rules and disclosed all the facts, methods used, assumptions and estimates, then this is not fraud. All this is, is aggressive accounting and the market will typically mark a share price down due to it having lower quality earnings here.
Once again, this is not fraud. If anything, it is just #3 above: people following their incentive. In this case, the incentive is often to make the company’s results look as good as possible within the legal framework available.
Actual, real fraud:
And then there is actual fraud.
This is where something or somethings have been hidden, changed, or manipulated through means that are not legal.
There are always three things that exist in a true fraud:
- Means: Fraud is always committed by a person or people in a position to commit such fraud. I.e. You need to be a position of power and authority to commit fraud. In listed companies, this is typical of a management role and/or executives (and sometimes non-executives) on the Board. Look around and ask who signed off on the fraud? The answer will typically be the person or people involved in it.
- Motive: Fraudsters want to get something out of the fraud. In the stock market, this is typically money or an inflated share price. Either or both make the fraudster(s) rich. No one does fraud for free. Look around and ask who stands to gain from the fraud? The answer will typically be the person or people perpetrating it.
- Rationalisation: Fraudsters are human too and need to sleep at night. Typically, most fraudsters don’t believe that they did much wrong. Rather, fraudsters believe that they are/were being “smart” and “gaming the system”. This rationalization for breaking the law and ruining people’s lives is also often the reason fraud perpetuates for so long: the fraudsters are the loudest at defending their own actions. Look around and ask who has a track record of “flying close to the Sun” or bending rules? Who has constantly defended these actions? These are often the sociopathic perpetrators of what eventually becomes major fraud.
In closing, I hope I’ve been quite clear in making my point: Fraud exists, but often the word is misused.
Bad businesses can be perfectly ethical and legal. Rubbish management teams can operate entirely within the rules. Aggressive assumptions in financial statements can be perfectly legitimate. Plenty of these exist and it is our job to sift through it all and build our own views on the worth of these businesses. These are all still real businesses and the only thing up for interpretation is how much their shares are worth. And then, occasionally, true and undiluted fraud exists. It will always exist somewhere and somehow (but don’t let the short-sellers misuse this word for their own profit). When there truly, really is fraud, then nothing can be relied on and the entire business may simply not exist. And, therein, lies the market’s fear of fraud.