Are Activist Investor's Market Manipulators? [Published on June 2017]

On March 24th, during a seemingly normal Friday in the Hong Kong stock market, chaos broke when Huishan Dairy’s share price plunged 85%, wiping out about $4.1bn in market value before the company stepped in to halt trading. There was no warning nor was there an immediate explanation for the sudden crash of one of the most stable stocks traded in Hong Kong.

However, in December last year, activist short seller Muddy Water published a two-part 60-page report announcing they were taking a short position in Huishan Dairy, accusing them of alleged numerous operating and accounting frauds and confidently stated their trademark phrase, “this stock is worth close to zero”.

Muddy Waters founder and CIO Carson Block first became famous in 2011 when its short sell report led to the bankruptcy of Toronto-listed Chinese company Sino-Forest. Since then, and now, traders take notice of tweets from himself or Muddy Waters, and whenever he appears on television because his comments can move markets.

What Are Activist Investors?

Activist investors are those who have the resources and influence to have an impact on the direction of a company’s share price. High-profile hedge fund managers would often be activist investors, and they are almost always institutional investors.

Arguably the most famous activist investor is Bill Ackman, the Chief Executive Officer of Pershing Square Capital, a New York-listed hedge fund. Back in 2012, Ackman bet over $1bn on shorting sports nutrition company Herbalife, calling its multi-level marketing business model a pyramid scheme.

Herbalife and its billionaire majority shareholder Carl Icahn has vehemently denied Ackman’s claims on multiple occasions. This five-year saga still rages on today. Herbalife is currently winning as its stock price has risen nearly 40% since Ackman first attacked the company.

When investors short stocks, they borrow the stock from a broker to sell, then pay interest on the borrowing and any dividends the stock earns. Ackman is paying roughly $100m just to maintain his short position. In a June 2016 article, it states “[f]or Ackman to break even on his Herbalife short position, the hedge funder would have to see the stock to the low 30s.” One can expect the share price needs to be even lower now.

Back to Muddy Waters…

Carson Block visited Hong Kong to attend the Sohn conference on June 7th. The day before the conference, he paid a visit to Bloomberg’s office in Hong Kong and appeared on Bloomberg Markets: Asia. During the interview where he discussed topics on his short-selling research methodologies, Snap, and China’s economy, he explained that Chinese companies can manipulate their financial statements more easily and are, thus, more susceptible to fraudulent practices. When asked which company, he replied: “well you’ll have to find out tomorrow, but it will be Hong Kong-listed”.

The Hang Seng index fell after his comments, and some speculators began to short stocks that they thought would be named the following day. Some, including Andrew Clarke, director of trading at Mirabaud Asia, criticised Block for causing a panic sell-off in stocks that had no relation to his short target. Eventually, Block announced that Muddy Waters was shorting Man Wah, a Hong Kong-based manufacturer of furniture and household goods. Man Wah’s stock tumbled as much as 15% before ending the day 10.3% lower at HK$6.03 before the company’s shares are halted for trading. Man Wah has called those allegations “inaccurate” and “flawed” and has asked its lawyers to make a formal complaint to the Hong Kong securities regulator.

Market Manipulators?

Carson Block and Bill Ackman are only two of the many activist investors out there. The question is: are their actions legal?

Market manipulation is a serious offense, and those liable would be fined heavily, banned, and/or prosecuted. Common activities that could be classified as market manipulation include creating a false impression of liquidity and artificially raising or lowering share prices and deliberately presenting false information leading to share price movements that benefit their own portfolio holdings. One is interested in the latter.

While activist investors are vocal and possibly harsh about their opinions, they do not make audacious claims without credible evidence. For example, Muddy Waters’ claim to fame comes from the fact that their research has produced quite a consistent track record, so it is difficult to argue that they produce false information. Also, with regards to Ackman vs. Herbalife, John Coffee, a securities law professor at Columbia University of New York, said "[w]hile Ackman is playing hardball with Herbalife, his actions aren’t illegal, and accusations of market manipulation would be overblown."

Although research is based on objective information, opinions are subjective. This is the reason why analyst ratings can be different for the same stock because it ultimately depends on the opinion of the analyst in question.

Actual Power

Most importantly, the market may not necessarily be swayed by a single investor’s opinion no matter how credible he/she is. In 2014, after Ackman’s three-hour presentation where he labeled then-Herbalife CEO Michael Johnson “a predator” and labeled the company “a criminal enterprise”, the market shrugged it off, and Herbalife’s stock rose over 20% the next day. Furthermore, Man Wah’s shares have increased to HK$7.22 (as of 16/06/2017), 52 cents above the price on the day Block announced shorting the company’s stock. Therefore, while activists have profited from their actions, it does not always produce favourable results because it ultimately hinges on whether they can convince the market to move in the direction they want.

*Update [08/01/2019]: Man Wah's stock has now fallen to HK$3.02 following continued weakness in the retail and furniture sector, proving Carson Block right all along.

Lastly, having activist investors can help improve the market’s efficiency. If and when fraud is detected, this would create pressure for other companies to improve their own practices to increase shareholder value. Also, it creates an incentive for the local stock exchange to tighten listing rules or conduct regular financial checks to give investors and prospective companies confidence to invest in and list on the exchange respectively. While the actions of activist investors may raise a few eyebrows, they can raise corporate governance standards to avoid targets in the future.

To conclude, the answer to the question is: yes, it is legal and may even be beneficial in the long run.