Muddy Waters’ Answer to the French Woerth Report on Shareholder Activism in Europe
On October 2, 2019, a parliamentary mission from the French Finance, General Economy and Budgetary Control Commission submitted a report about the development of activism in Europe. This report aimed to answer the question of how to regulate such a new phenomenon as activism, widely seen as beneficial to capital markets but also, according to the report, prone to taking an ‘excessive form’. However, it reflects a profound misunderstanding from French authorities of the issues underlying the financial regulation of short selling.
First, the report fails to appropriately distinguish ‘long’ and ‘short’ activism, which are two fundamentally different practices. Second, and although this affirmation is widely contradicted by academic research, it considers large amounts of short selling of a given company as likely to reflect an ‘excessive practice’ prone to triggering undesirable self-fulfilling prophecies. More generally, the report's flaws are rooted in major conceptual mistakes on fundamental issues such as capital markets efficiency and corporate governance. These conceptual errors explain how such an absurd recommendation as introducing a ‘presumption of abnormal functioning of capital markets’ when a company's shares are heavily shorted. They also explain how the essential issue of corporate governance, which is a key factor behind the high level of both long and short activism in France, could be ignored.
In our paper, in the interests of the French capital markets and, ultimately, the French economy, we try to bridge the gulf that separates the French authorities and short sellers.
We begin with a detailed reminder of what short selling is and of the reasons why shareholders can benefit from lending their shares to short sellers, even though the latter bet in an opposite direction to the former. In fact, short selling exists precisely because shareholders draw great benefits, both direct and indirect, from lending their shares. The risk taken by short sellers, at a time when major equity indexes are constantly rising, also needs to be put into perspective with France's obsession for more regulation of short selling, which we interpret as largely encouraged by an erroneous representation of short sellers as careless speculators. This representation is all the more inaccurate given that short selling is a practice widely recognized, especially by the academic literature, as having beneficial effects for financial markets.
These preliminary explanations then allow us to reveal the absurdity of introducing a presumption of abnormal functioning of the market when a company is heavily shorted. Such an abnormal functioning, in the context of companies being heavily shorted, essentially happens only in exceptional circumstances—typically, financial crises. Moreover, when the market is functioning abnormally at a single company's level, the problem is already dealt with by market abuse regulations. Thus, the fact that a company is heavily shorted almost always reflects either a mistake on the investors' side (which cannot be considered as reflecting a malfunctioning of the market) or problems at the company's level. In fact, short sales are typically the consequence of a problem created by the issuer itself. Thus, implementing a presumption of abnormal functioning of the market because an issuer is subject to a lot of short sales simply is nonsense. Moreover, and assuming such a presumption should be implemented, the report omitted to discuss its possible sanction. This is all the more problematic given that triggering the presumption could have adverse consequences not only for short sellers, but also the market at large.
The choice of the report's authors not to discuss corporate governance issues is equally disputable. Most of the time, these issues are the primary concern of short sellers. It therefore does not make sense to distinguish the two issues (short selling and corporate governance) as if they could be dealt with separately.
Leaving short selling aside, two other recommendations show the misconceptions of the report's authors.
First, recommendation 1 pushes for lower threshold for ownership disclosures based on the UK example. Not only, however, is the English market very different from the French one (hence the inability to purely and simply transpose English solutions to the French context), but such a recommendation is in direct contradiction with the report’s own objectives.
Second, recommendation 13, suggesting that a nonbinding discussion guide should be issued with the purpose of normalizing the interactions between companies and activists, betrays a rather naive view of such relationships.
Finally, we formulate a few suggestions that we think are more reasonable given the current context. First, forcing shareholders who lend shares to short sellers to notify the French Market Authority—not the public—of their decision to massively recall the shares they lent (a practice known as a ‘short squeeze’ that can be extremely harmful to short sellers) would be an excellent way to mitigate excessive behaviour and market abuses, without putting excessive constraints on lenders. Second, it should be easier to hold directors liable for their misbehaviour. To a large extent, this would solve the problems that short sellers tend to criticize at their root. Thirdly, in company groups, untrue financial statements should be sanctioned at every level, including consolidated financial statements. Although this sounds obvious, the criminal offence for untrue financial statements under French law is today circumscribed to nonconsolidated financial statements. Finally, we suggest considerably reinforcing whistleblowers' protection and powers, since they are the first barrier against bad management practices.
Carson Block is the founder of Muddy Waters Research.
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