Watching the detectives of the stock market can help to answer questions

Are short sellers immoral parasites or clever analysts who help to expose ‘frauds, fads and failures’?

To many, attempting to profit from stock market falls is immoral and parasitic. Short sellers, however, see themselves as the detectives of the stock market, an argument that has been greatly strengthened by their exposure of fraud at Spanish wifi firm Gowex.

Gowex had long been the darling of the Spanish stock market, its value soaring from €49 million in 2010 to a peak of €1.9 billion in April. However, its success story smelt fishy to Gotham City Research, a secretive New York firm renowned for its aggressive approach. A fortnight ago, following eight months of research, Gotham published a 93-page report accusing Gowex of fraud. Days later, chief executive Jenaro Garcia fessed up, and the firm filed for bankruptcy.

It was a stunning victory for Gotham, given the renown with which Gowex was held in Spain. As recently as March, Garcia was lauded by Spanish prime minister Mariano Rajoy, who said society "needs entrepreneurial examples like you" and presented him with a "well-deserved" business prize.

Garcia had previously received an award for innovation at Ernst & Young’s Entrepreneur of the Year programme, while the country’s fund managers – the professionals who are meant to do their homework before committing investors’ money – had also missed numerous red flags.


One such warning sign, according to Gotham’s report, was the fact that Gowex’s auditor did not have a business email address and apparently worked out of one room in an apartment. Gowex paid auditing fees of just €52,798 in 2012 – a paltry figure for a company with declared revenues of €114 million.

Ironically, the report's publication only prompted the Spanish regulator to warn it would investigate Gotham for potential "market abuse". Little wonder, then, Gotham founder Daniel Yu views the entire debacle as one that "completely validates the critical role that short selling plays in the financial markets and the fact that regulators' initial response should not be to shoot the messenger". Short sellers, says Gotham, help expose "frauds, fads and/or failures".

Many examples back up that case. Short seller Jim Chanos, for example, famously exposed accounting irregularities at Enron back in 2000, and was also prescient in the run-up to the global financial crisis.

He also claims to have warned the G7 finance ministers in April 2007 – 17 months before the Lehman bankruptcy – that banks’ toxic assets were a danger to the global financial system, a message that was “completely and officially ignored”.

Another hedge fund manager, David Einhorn, spent 2008 warning of Lehman's accounting practices, while short sellers were also among the first to spot questionable accounting at WorldCom, Tyco and other major companies.

Despite this, they attract unenviable press attention. During the banking crisis in 2008, shorting of financial shares was banned in Ireland, the UK, the US and a host of other countries. Following heavy share price falls suffered by Anglo-Irish Bank and other financials in February 2008, then Financial Regulator Patrick Neary launched an investigation into "false and misleading" rumours apparently "connected to unusual trading patterns in Irish shares". Similar investigations were launched in the UK and the US, following (well-founded) rumours regarding the health of HBOS and Lehman Brothers.

This suspicion only increased as the banking crisis worsened, Scottish prime minister Alex Salmond decrying "short-selling spivs" and the Archbishop of York denouncing them as "bank robbers".

Tulip bubble

Antipathy towards shorts is not new. Shorts were blamed for the bursting of the Dutch tulip bubble in the 1600s. The practice was illegal in 18th century


, and Napoleon saw the short seller as “an enemy of the state”. The 1929 crash was blamed on shorts. In 1991,

Dennis Hastert

, the American speaker of the House of Representatives until 2007, described shorting as “blatant thuggery”.

Thankfully, he didn't propose mandatory caning for shorts, the preferred solution of the Malaysian Finance Ministry in 1995 (the beating "will be light, similar to the punishment carried out on juveniles").

As British equity analyst James Montier has said, shorts "have been vilified pretty much since time immemorial". Montier sees this as "strange, the equivalent of punishing the detective rather than the criminal".

Superior skills

Academics share Montier’s puzzlement. One study, for example, found high short interest tended to be a predictor of future negative news, concluding that shorts were “highly informed traders” with “superior analytical skills”. Another noted that internet stocks were more difficult to short than other stocks during the late 1990s, a factor that contributed to the dotcom bubble.

Another paper, authored by University of Chicago professor Owen Lamont, concluded shorts "play an important role in detecting not just overpricing, but also fraud".

Lamont's paper – Go down fighting: Short sellers vs firms – confirms that shorts' pessimism towards individual stocks tends to be well-founded. It also portrays them as all-too-frequent victims of market manipulation as opposed to the perpetrators. The study, which covered the 1977-2002 period, looked at the returns of 270 companies that made allegations of dirty dealing by short sellers.

“Battles between short sellers and firms can be extraordinarily acrimonious,” Lamont found. Companies uttered “belligerent statements” portraying short sellers as muck-spreaders engaged in conspiratorial action against them. Others took legal action; others undertook technical moves to prevent short sellers from increasing their positions.

If such actions were designed to prop up the share price, they failed. On average, the companies’ share prices had fallen more than 40 per cent within three years. Many of the companies were subsequently charged with fraud.

“Perhaps only firms that believe themselves to be overpriced engage in anti-shorting actions, since underpriced firms know that the market will eventually recognise their true worth,” Lamont suggests.

‘Instinctive reaction

’ Despite the research, policymakers and the general public “seem to have an instinctive reaction that short selling is morally wrong”, Lamont notes, with practitioners facing “periodic waves of harassment from governments and society”.

Despite the Gowex success, Gotham's aggressive tactics and secretive behaviour are likely to remain controversial. However, it's hard to disagree with the firm's key message. "Auditors, regulators, lawyers, investment bankers, and others rarely detect fraud. Insiders and short sellers do." Quick time: How short selling works What is short selling?

Short selling is when a trader attempts to profit from market declines.

How does it work?

The short seller borrows shares he doesn’t own, sells them and eventually closes the transaction by buying them back.

Say again?

Think of it this way. You believe XYZ will fall in price and ask your broker to lend you 1,000 shares at €10. You then sell them, pocketing €10,000. A month later the shares are trading at €8. You pay €8,000 and give the shares back to your broker. The difference – €2,000 – is yours to keep, minus a fee charged for the lending of the shares.

What happens if the price keeps going up?

Losses are potentially unlimited. Shorts will often use stop-loss orders that will take them out of a position if the security trades beyond a certain level, so timing is crucial. Additionally, the most a short seller can gain is 100 per cent, unlike conventional investments, where the maximum loss is limited to the original investment and gains are potentially infinite.

So it’s not immoral, but it is risky?