Hindenburg

The basic business model of an activist short seller is:

1. Investigate a company, ideally using only public sources. [1]
2. Find out that the company is bad.
3. Short its stock.
4. Put out a public report describing your findings — “this company is bad” — in a zippy, emphatic, hopefully accurate way.
5. Watch the stock go down, because people read your report, realize that the company is bad and dump the stock.
6. Profit, by covering your short at the new, lower market price reflecting the new, accurate, bad information that you have published about the company. [2]

Obviously some short sellers, sometimes, will deviate from this ideal model. They will investigate a company using nonpublic information, for instance, or their report will be inaccurate. But assuming that they follow the ideal model: Is this okay? Are you allowed to do this?

In the US, I think the answer is clearly yes, but people do get mad about it. There is some apparent intuition that it is market manipulation: You are betting that a stock will fall, and then you are making it fall (by publishing your report), and that seems somehow like cheating. In practice, most people who don’t like it will complain that the report is inaccurate — it is more clearly market manipulation if the report is wrong — but I think that some of this really is driven by suspicion of the whole business model. Even if the report is entirely accurate and based on public information, something about the model strikes people as icky.

Here is a slight complication of that business model:

1. Investigate a company, ideally using only public sources.
2. Find out that the company is bad.
3. Write a report describing your findings — “this company is bad” — in a zippy, emphatic, hopefully accurate way.
4. Sell that report to some other, larger, better capitalized hedge fund.
5. That fund shorts the stock.
6. You publish the report.
7. Watch the stock go down, because people read your report, realize that the company is bad and dump the stock.
8. The other hedge fund profits, by covering its short at the new, lower market price reflecting the new, accurate, bad information that you have published about the company. 
9. It gives you a cut of the profits.

This is a more complicated model, but it makes more sense given the economic and social reality of activist short selling:

• If you are an activist short seller, you are normally pretty specialized: Finding and investigating bad companies is your calling, and you’re not also out there making tons of deep-value long bets or whatever. [3]
• Stocks mostly go up, so it is hard to run a hedge fund that only makes short bets: Who would want to invest? [4]
• Also it is just possible that the personal characteristics that make you a good activist short seller (cynicism, combativeness) will also make you bad at raising money from clients.
• So if you’re good at identifying bad companies and writing punchy reports about how they’re bad, you might not be in a position to make a big bet on your report, because you just don’t have a lot of capital. [5]
• Meanwhile plenty of other, bigger hedge funds would love to have some good short ideas, but don’t want to pay a full-time analyst to go around digging for frauds. They’ll happily give you a share of the winnings if you bring them your ideas.

What about this model? I think people find it even ickier. In particular, there is something about the collusion between the short researcher and the hedge fund that rubs people the wrong way. Surely it is unfair for the hedge fund to trade on the researcher’s report before it is published. The report is nonpublic information (it hasn’t been published yet), and it is material (if it causes the stock to go down), so isn’t it insider trading for the hedge fund to trade on it?

Again, I think that the answer in US law is no, this is fine. Insider trading, I like to say, is not about fairness; it’s about theft. It’s illegal to trade on material nonpublic information that you get in violation of some duty to someone; trading on your own information — like “I am about to publish this report” — is fine. Here, the short researcher owns the information (the report), and wants the hedge fund to trade, so it’s fine. But I should stress:

1. Nothing here is legal advice.
2. It icks people out, even if it is legal, and there are constant rumors of US investigations into collusion among short sellers.
3. The US has somewhat unusual insider trading rules, and in other countries there is more of a risk that any trading on material nonpublic information might be illegal.

Last year, US activist short research firm Hindenburg Research published a report on India’s Adani Group, titled “Adani Group: How The World’s 3rd Richest Man Is Pulling The Largest Con In Corporate History.” “Over two weeks, the report wiped out more than $110 billion from the conglomerate’s pre-Hindenburg value, pushed some of its bonds to distressed levels and caused Adani to shelve stock and bond offerings.”

Yesterday, Hindenburg published an “Adani Update – Our Response To India’s Securities Regulator SEBI.” At Bloomberg News, Sanjay P R reports:

The firm also posted on its website the full “show cause” notice it said it received from the Securities and Exchange Board of India, or Sebi, in June, which states that Hindenburg’s report on the Adani Group had certain misrepresentations and inaccurate statements that were meant to mislead readers.

In the 46-page document, Sebi said Hindenburg “has resorted to extrapolation and conjecture to emphasize some facts and understate others in favor of negative inference against Adani Group Companies.” It also said the short seller cited a broker banned from the securities market, shaking investors’ trust in the regulatory framework.

Hindenburg in turn said India’s markets regulator failed to address the fraud allegations in its report last year.

Sebi “seems more interested in pursuing those who expose such practices” while its investigation into billionaire Adani’s empire has hit a wall, Hindenburg said.

Here is the Sebi notice that Hindenburg posted. There is, of course, some argument over whether Hindenburg’s Adani report was accurate. Sebi says:

During investigation, it was also observed that the Hindenburg Report contained certain misrepresentations/ inaccurate statements. These misrepresentations built a convenient narrative through selective disclosures, reckless statements and catchy headlines, in order to mislead readers of the report and cause panic in Adani Group stocks, thereby deflating prices to the maximum extent possible and profit from the same. …

It was observed that the Hindenburg Report deliberately sensationalized and distorted certain facts through the use of catchy headlines such as “Scandal.”

Hindenburg argues, though, that Sebi doesn’t really identify any material inaccuracies; it just doesn’t like that the Hindenburg report is written in the zippy, argumentative style of a short report. [6]

But Hindenburg also points out that the discussion of alleged inaccuracies is brief and starts on page 24 of the 46-page Sebi order. Sebi’s main point is something else: Hindenburg monetized the trade by selling it to a bigger hedge fund, and Sebi doesn’t like that. Bloomberg reports:

Sebi’s notice also named US hedge fund Kingdon Capital Management as an involved party, stating that Kingdon knew about Hindenburg’s research on the Adani Group before it was published and had a profit-sharing pact with the short-seller on its trades.

Hindenburg shared a draft of the Adani report with Kingdon in November 2022, nearly two months before it published the report, according to the Sebi show cause notice. In return Kingdon agreed to share 30% of its net profits from trading securities related to Adani with Hindenburg. That profit-sharing then got reduced to 25%, due to the cost of setting up these trades. ...

As of June 1, the Kingdon fund returned $4.1 million of the gains from the Adani short sale to Hindenburg while another $1.4 million has yet to be shared, according to Sebi.

Again, this is the fairly standard business model — “much of the notice seemed designed to imply that our legal and disclosed investment stance was something secret or insidious,” says Hindenburg — but you don’t have to like it. Sebi says:

Noticee No. 1 (Hindenburg) colluded with Noticee No. 3 (Mr. Mark E. Kingdon) along with Noticees Nos. 4, 5 and 6 i.e. Kingdon entities, in a scheme devised to use advance knowledge of non-public information (“NPI”) regarding the existence, timing, and overall nature of the Report, to enable Noticee No. 6 to build short positions in the futures of AEL [Adani Enterprises Ltd.] and share profits accrued from squaring-off the positions at prices deflated due to publication of the Hindenburg Report in a manner designed to lower scrip prices to the maximum extent possible. ...

Therefore, it is alleged that Hindenburg and Kingdon entities dealt only in securities of AEL while in possession of NPI regarding existence, timing, and overall nature of the Hindenburg Report on Adani Group securities including the securities of AEL and profited unlawfully from the price deflated due to publication of the Report, without ensuring compliance with the [Research Analyst] regulations. This also constituted an unfair trade practice which prejudiced good faith dealings in the shares of AEL, by ordinary investors.

That at least suggests that, even if every word in the Hindenburg report was true, it would still be illegal, because Hindenburg showed it to Kingdon, and Kingdon traded on it, before it was published. [7] People really do not like activist short sellers and think they should be illegal, and some of those people are securities regulators.