The Dangers of Short-Selling Disclosure

During the bull market’s past nine years, short-selling has been a torturous endeavor, perhaps even a career killer. And now, to make matters worse, there’s a new effort to force short-sellers to disclose their positions.

A short-seller disclosure act is being promoted by the exchanges and by the target of the most transparent short bet in recent memory: Herbalife, the multilevel marketing company. Herbalife is now under the eye of an independent monitor, after paying $200 million to settle a Federal Trade Commission investigation — thanks to short-seller Bill Ackman of Pershing Square Capital Management.

The lengths to which Herbalife, and its investors, went to try to crush Ackman are clearly one reason other short-sellers fear mandating such transparency. It might crush them too.

Attempts to make short-sellers reveal their positions are nothing new. In the depths of the 2008 financial crisis, short-selling was even banned for several days. Later, during the debate over the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress considered forcing short-sellers to disclose their positions. But that did not happen, and it appears that short-sellers — which include the big Wall Street firms and every multibillion-dollar hedge fund — dodged a bullet.

Now, however, the New York Stock Exchange, the Nasdaq, the Biotechnology Innovation Organization (its members are a common short target), and the National Venture Capital Association have teamed up with Herbalife to put forth a new bill.

So far, the proposal is only a memo and does not have a congressional sponsor. As written, the so-called short position transparency act would force short-sellers to disclose their positions to the Securities and Exchange Commission if they obtain an interest in an equity security that is more than 5 percent of the security’s average reported weekly trading volume over the previous four weeks — and to report those trades within ten days. Although the act’s stated purpose is to bring long and short disclosures in sync, no similar disclosure is required for longs. A 13D filing is mandated within ten days after an investor amasses more than 5 percent of a company’s total shares, but there’s no requirement for one that simply accounts for 5 percent of the trading during the previous month. (Quarterly filings disclosing a fund’s publicly traded long positions are made 15 days after a quarter’s end and as such are backward-looking and often out of date.)

News of this latest effort came to light last month via Fox Business Network reporter Charles Gasparino, who said a senior Herbalife official had told him it was “very instrumental in leading the effort.” A memo outlining the proposal, dated October 2017, has been passed around on Capitol Hill, but it has gone nowhere so far.

Nonetheless, short-sellers are already up in arms. In a Twitter poll by Activist Insight, 79 percent of participants said such disclosure is a bad idea. Carson Block’s Muddy Waters Research, a famous short-seller, tweeted, “It’s appalling how @NYSE and @Nasdaq are reportedly teaming up with $HLF [Herbalife] which paid a 9-figure fine, to target short-sellers . . . when HLF’s wrongful conduct was exposed by a short.”

Even renowned Herbalife booster and shareholder John Hempton of Bronte Capital is upset. “The Bill is a threat to my physical safety,” he wrote on his blog. Hempton is also known for short-selling.

The European Union requires disclosure of short sales, which doesn’t seem to have hurt its capital markets. But it’s one reason Sahm Adrangi, founder of Kerrisdale Capital Management, says he never shorts U.K. stocks.

The proposed U.S. act would affect all activist short-sellers like his fund, Adrangi says. Even though activists go public with their criticism of a company once they’ve built their position, shorting requires borrowing shares from those willing to part with them. That can take much longer than a similar effort on the long side, experts say. A ten-day window simply would not give short-sellers enough time before being forced to publicize their position. If a stock were to fall precipitously before a short-seller had finished building his short, his potential profits would diminish.

Investors short companies for many reasons. But the best shorts are on frauds masquerading as legitimate companies, which makes short-sellers’ efforts essential to cleaning up markets. Moreover, such companies are likely to go to great lengths to stop opponents.

As for Ackman, he has largely exited his Herbalife position, losing hundreds of millions of dollars during his more than five-year battle. When he placed the short back in 2012, many peers criticized Ackman for being so public, arguing that telling the world he had a $1 billion short on Herbalife made him a target. Others could gang up to try to squeeze him — make him cover by bidding up the shares.

That is precisely what happened. Even before Carl Icahn became a major investor in Herbalife, he predicted that Ackman’s short would face “the mother of all short squeezes.” A slew of hedge funds jumped into the stock in 2013, led by then–Soros Fund Management portfolio manager Paul Sohn. “If Soros could break the Bank of England, it could break the back of Ackman,” Sohn said at the time. Sure enough, the stock surged, forcing Ackman to convert a portion of his short into put options, as he revealed in an investor letter that became public. Last fall the stock spiked as Herbalife bought back shares, and Ackman exchanged all of his stock short for put options, again disclosing his actions. As the stock continued to rise, Ackman began to unwind his short and is now almost entirely out. That was also disclosed.

Putting the merit of the arguments about Herbalife aside, Ackman’s transparency and massive losses should serve as a warning to other shorts. All activist hedge funds could face similar consequences were this act ever to become law.