A bright light is being shone on a murky area of market regulation.
The North American and Chinese investigations of Muddy Waters LLC, the research firm that last week delivered a damning report of the TSX-traded Chinese forestry company Sino-Forest Corp., raise new questions about the role of regulators in addressing complaints about short-sellers who issue negative comments.
The Ontario Securities Commission said Wednesday it will look into the controversial allegations which have knocked millions of dollars of value off Sino-Forest's shares.
In the past week, some investors have profited handsomely at the expense of others because of the allegations outlined by Muddy Waters. While researching a company and trading on that information is a central tenet of the markets, what happens if an investor shares the research, causing a massive fluctuation in the stock price, and it turns out to be wrong?
Experts say it is an area that regulators have been loath to delve into, because the cases can fall in shades of grey.For instance, what if allegations are partially correct but wildly exaggerated? What if the party making such allegations truly believed them but they were nevertheless wrong? Despite the difficulties involved in sorting through these situations, regulators, especially in the U.S., have recently signalled that this is an area that they want to clean up.
Both Universal Market Integrity Rules and Ontario's provincial securities laws have prohibited manipulative or deceptive trading for close to a decade, since authorities sought to crack down on various aspects of market conduct in the post-Enron era.
Provisions to prohibit individuals or companies from making statements they "know or reasonably ought to know" are false - and could reasonably be expected to have a significant effect on the market price of a stock - were added to the Ontario Securities Act in 2002, but did not come into force until Dec. 31, 2005.
Former Ontario finance minister Janet Ecker, who brought in the 2002 legal reforms, said that "hypothetically speaking, if an analyst is issuing advice that is seriously off-base then there needs to be consequences."
That's a lesson that was confirmed by the financial crisis, and it's why senior executives from financial institutions, rating agencies and regulators have been called to account for the information and views that they had expressed, which investors felt they could rely upon, Ms. Ecker said. "A short seller is not in the same situation as a market regulator, but that does not mean that people should be able to pass views with impunity."
Mr. Block has bluntly alleged that Sino-Forest is a "fraud," which the company rejects and has backed up with documents. If it turns out he's wrong, then he could find himself accused of fraud, experts say.
If the allegations turn out to be false, then U.S. law enforcement is likely to take up the case given the profile that it has received and because Mr. Block is American, says Jacob Frenkel, a former enforcement lawyer at the U.S. Securities and Exchange Commission and current chair of securities enforcement, white-collar crime and the government investigations practice in the Washington area at law firm Shulman, Rogers.
The problem for companies whose reputations have been damaged by false allegations is that regulators could spend years investigating.
"Even if the securities commission were working day and night, it is going to take time to conduct an investigation and it is going to take time to sift through the information and come out with what the right answer is, because a lot of these things will be matters of judgment," said René Sorrell, a partner at McCarthy Tétrault LLP. "The way that the securities law works, it's up to the public companies to get the right facts about the company on the record."
That's why, after much debate, Prem Watsa, the chief executive officer of Toronto-based insurer Fairfax Financial, decided to launch a lawsuit five years ago in New Jersey against a group of hedge funds and analysts that Fairfax accuses of conspiring to spread false allegations about the company in order to drive down its stock price and profit from short positions. The case is still before the courts and has not been proved.
"This is only the second suit we have filed in our history," Mr. Watsa said. "It was a tough decision that we made very reluctantly. We concluded it was our duty to act."
Michael Bowe, a lawyer representing Fairfax in its case, said that "public companies faced with the purposeful dissemination of disinformation are in a difficult spot. Regulators have finite resources and the regulatory process takes time. On the other hand, if a public company pursues legal action itself, it is often criticized for trying to silence critics or [for]getting distracted."
At the moment, the SEC is seeking public comment on potential new short-selling disclosure regimes as a result of the Dodd-Frank reforms that seek to clean up Wall Street in the wake of the financial crisis.
Among other things, the SEC is asking the public to "comment on the ways and extent to which, if any, commenters believe trade-based manipulation (i.e., manipulating without a corporate action or spreading false information) using short sales is possible?"
Janet McFarland
David Ebner