Policing Financial Markets: An Analysis of Whistleblowing Short Sellers’ Rhetoric Luc Paugam HEC Paris and SnO 1 rue de la Libération, 78351 – Jouy-en-Josas – France Tel: 33 1 39 67 72 37 Email: [email protected] Hervé Stolowy HEC Paris 1 rue de la Libération, 78351 – Jouy-en-Josas – France Tel: 33 1 39 67 94 42 Email: [email protected] Yves Gendron Université Laval Faculté des sciences de l’administration Pavillon Palasis–Prince 2325, rue de la Terrasse – Local 2636 Québec (Québec) G1V 0A6 – Canada Tel: 1 418 656-2131, ext. 2431 Email: [email protected] This version: May 15, 2019 This version is a preliminary draft. Please do not cite or distribute the paper without the authors’ permission. Acknowledgements. The authors express their gratitude to the whistleblowing short sellers who accepted to be interviewed for this research. The authors gratefully acknowledge comments from Andrea Bafundi, Veronica Casarin, Mark Desjardine, Rémy Dumoulin, Alper Darendeli, Rodolphe Durand, Andrei Filip, Beatriz Garcia Osma, Christopher Hossfeld, Julien Jourdan, Romain Laufer, Anne Le Manh, Andreea Moraru-Arfire, Thomas Obloj, Paul Pronobis, Bertrand Quélin, Tan Hun Tong, Philippe Touron, Georg Wernicke and Huaxiang Yin, and workshop participants at the University of ESSEX (United Kingdom, December 2018), the HEC Paris – SnO research center (Paris, December 2018), ESCP Europe (January 2019), Alliance Manchester Business School (February 2019), ESSEC Business School (February 2019), Fundación Ramón Areces, Madrid (March 2019) and Nanyang Technological University (March 2019). They thank Xucheng Shi, PhD Student at HEC Paris, for helping with the textual analysis and the latin transliteration of Chinese and the explanation on the meaning of the Chinese text. Responsibility for the ideas expressed, or for any errors, remains entirely with the authors. Hervé Stolowy expresses his thanks to the HEC Foundation for funding the research project 9B82F1901+. Luc Paugam acknowledges the financial support of SnO center. Luc Paugam and Hervé Stolowy are members of the GREGHEC, CNRS Unit, UMR 2959. The authors acknowledge the able research assistance of Emmanuel Da Costa, HEC Paris Master student. Policing Financial Markets: An Analysis of Whistleblowing Short Sellers’ Rhetoric ABSTRACT: How do market participants police companies listed on financial markets? We investigate, in this respect, the role of Whistleblowing Short Sellers (WSSs), i.e., short-selling organizations that target publicly listed firms that they perceive to be overvalued, in an increasingly popular form of “research reports” openly denouncing frauds, flawed business models, accounting irregularities, and wrongdoings. Our empirical analysis exploits 383 research reports targeting 171 unique firms and three first-hand interviews with WSSs. We focus on six WSSs that historically have issued informative research reports (-11.2% cumulative abnormal returns in the three days surrounding the first report’s release date; close to 50% of targets delisted, suspended or bankrupted subsequently). Drawing on Aristotle’s rhetoric, we examine how WSSs use narratives to convince other investors that target firms are overvalued. We decompose the documents produced by WSSs into stylized narratives related to credibility-based (ethos), emotions-based (pathos), and logic-based (logos) rhetorical strategies. To assess the impact of these strategies, we examine the extent to which the WSSs’ rhetorical strategies resonate in 3,665 press articles covering target firms 30 days after the first WSS report. In 59% of covered cases, the press refers to logos-based rhetorical strategies focusing on demonstrating overvaluation. In 51.7% of covered cases, the press also refers to pathos-based rhetorical strategies focusing on making fun of or using irony against the target firm. Considering the importance of the press in shaping investors’ opinions, our study points to WSSs playing a significant role in policing financial markets; their role is all the more pertinent given traditional gatekeepers’ difficulties in monitoring fraudulent behavior in financial markets. Keywords: whistleblowers; activist short sellers; persuasion; rhetoric; credibility. JEL Classifications: G14; G23; G3; M4; P1. Data Availability: Most of the data is available from public sources identified in the paper. The complete transcripts of interviews with WSSs, however, remain confidential. 1 I. INTRODUCTION Recently, financial markets have seen the development of a new type of whistleblowers: short- selling entities that actively engage in “equity research” to expose alleged wrongdoing by listed companies through the dissemination of “research reports” on their own websites, on Twitter, or on popular finance forums. Through their work, these “Whistleblowing Short Sellers” (WSSs) seek to inform market participants of fraudulent schemes, flawed business models, and accounting irregularities at publicly listed target firms. Those organizations often take (usually openly) “short” positions on the stocks of target firms, which implies that WSSs benefit from declines in the stock price of target firms. It is widely recognized that fraud, either in the context of organizational settings or financial markets, is a predominant socioeconomic problem that is considerably challenging to address (Cooper et al. 2013). A range of approaches have been considered in trying to make sense of the problem and different technologies have been implemented in striving to control for fraud in business and financial markets (Morales et al. 2014). Yet in spite of these significant efforts, fraud is generally viewed as an enduring problem, including in financial markets (e.g., International Organization of Securities Commissions (IOSCO) 2005). Drawing on Flyvbjerg’s (2001) call for social sciences to engage more firmly in research that matters, one key question to address relates to the policing of listed companies’ fraudulent and dubious behavior in financial markets. It is in a specific context that the emergence of WSSs as a new type of gatekeeper takes on socioeconomic significance, namely, as an innovative practice that developed in the private sector in order to detect and report on fraud cases taking place in listed companies. WSSs have exposed a number of well-publicized accounting frauds. A well-known example is Gotham City Research, which alleged in 2014 that the Spanish firm Let’s Gowex was perpetrating a massive accounting fraud. Let’s Gowex filed for voluntary insolvency five days after the whistleblower published a detailed report accusing it of misleading investors. Another example is Iceberg Research that, in 2015, started releasing a series of research reports targeting the (then) largest Asian commodity trader: Noble Group. The target firm subsequently booked large impairments, was downgraded by credit rating agencies, restructured its debt, and faced a 65% decline in its stock price in 2015 alone – confirming the original concerns raised by Iceberg. Other well-known WSSs of this type comprise Citron Research, Copperfield 2 Research, Glaucus Research, and Muddy Waters Research.1 In this paper, we focus on this group of six established WSSs that, in aggregate, have produced a large number of informative research reports since their creation.2 Their reports are informative as we estimate a negative average market-adjusted stock returns of -11.2% in the three days surrounding the issuance of the first research report, which represents on average a reduction of $416 million of market value for the target. Cumulative abnormal returns two months (six months) after the first research report are persistently negative: -14.5% (-22.6%). In addition, in August 2018, 46.3% of target firms are classified as either dead, delisted, or suspended from stock exchanges confirming the significant problems identified by WSSs. WSSs’ websites, when they exist, usually include little information about these private organizations. Some reportedly employ a small team (sometimes, most likely one person) of analysts who possess technical expertise in financial analysis, credit analysis and finance as well as a capacity to analyze documents written in different languages (e.g., Mandarin). Some WSSs rely on a larger team to conduct due diligence and investigative work. Some favor secrecy (e.g., Gotham City or Copperfield).3 Conversely, others are often active in the media to present their latest research reports. For example, Muddy Waters’ director of research, Carson Block, regularly gives public interviews to business TV channels such as CNBC or Bloomberg.4 Citron’s Executive Editor, Andrew Left, also appears regularly in the media.5 We assume that WSSs’ policing of financial markets develops the use of rhetorical strategies to increase the persuasiveness of allegations conveyed especially in their research reports. Persuasion is of significant importance in this setting. First, WSSs go against the consensus reached by other investors about the value of target firms. Investors tend to be skeptical toward extreme views that are far from the consensus. Second, WSSs have a clear conflict of interest: why should investors believe entities that benefit from a declining stock price of a target firm? Third, WSSs make allegations against legitimate firms that are audited, regulated by agencies such as the SEC, covered by the media, followed by analysts, managed by CEOs with credentials, and that employ hundreds or thousands of people. How could WSSs 1 For the sake of simplicity,