Not falling short: The rise of short selling in China

The reason why so many CCSs were involved in fraud scandals derives not only from the fact that Chinese companies were extremely keen to list on overseas bourses without complete preparations or knowing about foreign capital markets regulations, but also from the actions of many professional short sellers. In the US for example, both institutions and individuals could become short sellers. In particular, some intermediary organs that once served as financial consultants assisting Chinese companies on their overseas listings suddenly changed into short sellers as soon as market conditions changed for their clients.

To help halt the credit crisis, CCSs should improve their finances and credibility by auditing themselves when adapting to the oversight of regulatory regimes overseas. Towards short selling during an overseas listing, CCSs should adopt active actions against bad faith short sales. Usually information concerning a short sale is released without enough evidence and short sellers will make a profit as stock prices become reduced. Due to this, short sellers may magnify negative news relating to CCSs. If CCSs think that short sellers are conducting fraudulent actions to drive down their share prices, it can take legal action to protect themselves. For example, Sino-Forest is commencing legal litigation against short sellers Carson Block and Muddy Waters. This will be the first case since the credit crisis where a CCS is hitting back at short sellers.

Short selling is a framework that allows investors to make profits when stock prices are falling in developed capital markets. This objectively drives forward the healthy development of the whole market. Short selling allows for large-scaled adjustment effects upon the whole market, which helps avoid volatile stock prices and the phenomenon of a one-sided market. When an industry is disparaged or a listed company incurs problems in its business management model, investors will transfer capital or other resources to some more vigorous industries or companies with more potential. A binding force of short selling is that it helps stock prices go closely to the original value of the stock. China is inducing short selling to improve its capital markets and enrich the development of the national economy.

The rise of short selling in China

As of April 8 2010, Stock Index Futures (SIFs) landed on the China Financial Futures Exchange (CFFEX). During SIFs transactions, investors are not required to make a full payment equal to the value of contracts related to the SIFs, they just need to pay fees at certain ratios as guarantees. SIFs transactions have adopted short selling by way of a two-way business exchange. That short selling is being used by SIFs on the CCFEX is deemed to be a milestone indicating the advancement of short timing in China.

However, we need to recognise that the current short selling mechanism is just applicable to SIFs, and SIFs transactions are only allowed on the CFFEX. Those trades occurring on the Shanghai and Shenzhen stock exchanges do not allow short selling directly. So right now, the applicable scope of short selling is rather limited in China. However, the separation between the Futures Exchange and the stock exchanges objectively benefits not only the professional management of SIFs, but also forces the government to set up a regulatory framework to develop this new financing model of short selling. This separation also helps reduce the riskiness of new financial derivatives at an early stage. Regulating short selling and effecting positive influences of the mechanism is a long term journey.

At present, the Rules Regarding Stock Index Futures (股指期货交易规则) (Rules) and its Operating Measures directly govern the actions relating to SIFs. As of May 4 2011, the China Securities Regulatory Commission (CSRC) promulgated the Guidelines for the Participation in Stock Index Futures Trading by Qualified Foreign Institutional Investors (QFIIs) (合格境外机构投资者参与股指期货交易指引) (Guidelines), which regulates the participation of QFIIs with respect to SIFs. The Guidelines limit the participation of QFIIs in scope and in quota requirements. Although the Chinese government has clearly adopted a cautious attitude towards the participation by QFIIs in SIFs in China, the participation of large-scale QFIIs with substantial overseas experiences helps to activate the SIFs market and mature short selling in the PRC.

As of October 26 2011, the CSRC amended Measures for the Administration of Margin Trading and Short Sale of Securities of Securities Companies (证券公司融资融券业务管理办法) (the Measures). The Measures clearly regulate that securities companies are entitled to engage in the business of collecting funds and securities, and that securities companies may lend funds to clients for purchasing listed securities or lend listed securities to clients to sell borrowed stock. Securities companies have the right to collect property or assets as guarantees. To regulate the market and reduce potential risks, the Measures stipulate high requirements for securities companies and clearly provide the principle of business, the guarantee of credit, the handling of rights and interests, etc. However, the Measures only govern securities companies and only provide a general outline of related transactions without details. To this date there are no implementation rules regarding the Measures issued and therefore enforcement is still uncertain.

Application of short selling

Relationship between government and the market

In the US capital markets, the government does not strive for control and even the Securities and Exchange Commission (SEC) simply adopts an oversight role. The effects of short selling are assumed to be enough of a deterrent. China has achieved great progress in the construction of a market-oriented economy over the past three decades, however, the adjustment mechanism adopted by the Chinese government depends heavily upon frequently changing policies.

On June 24 2011, the dean of the CSRC's research centre, Qibin said on a top web forum that China had the largest number of initial public offerings (IPOs) globally in 2010, and that this trend would continue for the next 10 years. Was this data determined by the government? Public data indicated that China did indeed have the largest number of IPOs, but the results of them were not as satisfactory as expected. By the end of June 30 2011, 112 of the 167 newly-listed stocks were listed at below their original IPO price.

Short selling is a capital operating framework in a mature market economy that relies heavily on market perception. It easily fluctuates and is affected by government policies. Therefore if short selling is to take off successfully, there needs to be higher requirements of the Chinese government. It is a challenging issue to handle the relationship between the government and the market, and regulate the economy with an invisible hand.

Improve the build-up of a legal regulatory system

The US promulgated the Dodd-Frank Financial Reform Bill in 2010, approving the validity of short selling in that market. Securities lending, a popular business on Wall Street, created prerequisites for short selling. Precedent cases concerning fraud in bad faith with relation to short selling has helped to guide and regulate it in the judicial field. It is without question then that a stable and sound regulatory system is a precondition for the short selling mechanism to be successful in China. In contrast, right now the PRC limits short selling to SIFs only. The relevant regulations and industry rules are just at an early stage.

The weaknesses of short selling are obvious. Numerous short sellers maliciously release false information by way of a short sale, which directly disrupts the normal order of the market. Subject to article 11 of the Guidlines, where QFIIs participating in the trade of SIFs violate related PRC laws or regulations, the CSRC will take actions against such QFIIs. The CSRC is an administrative organ entitled to administrative powers and the foresaid provision is blurry. A CCS can lose CAD$6 billion within three months, which shows the great damages caused by short selling. Current administrative penalties against fraudulent actions related to short selling are hazy at best and do nothing as a deterrent to protect the interests of investors and the performance of the market.

The PRC Criminal Law (中华人民共和国刑法) does not clearly regulate actions in connection with short selling. Short selling fraud actions are not governed or punished due to a lack of relevant laws in the PRC. Therefore, as short selling develops in China, a proper regulatory framework needs to be built up accordingly.

Improving the risk awareness of investors

Public investors need to improve their risk awareness to guide rational investments and figuring out how to do this remains a significant challenge. In particular, the introduction of short selling demands high levels of risk awareness and capital investment technologies by the public. Information disclosure is an important characteristic of short selling, so the improvement of the public's risk awareness lends to bettering the regulatory framework concerning information disclosure, and the supervision of listing companies and governmental authorities.

Enhancing enterprise quality and involving international competition

The fundamental reasons why CCSs incurred a credit crisis are mainly attributed to themselves. Short selling will sweep away disqualified enterprises and leave the legitimate and competitive ones in the marketplace. With a decrease in the number of targeted companies, short selling will reduce their influence on CCSs. The introduction of short selling does favours to increase the oversight on domestic listing companies, improve standard performance and enhance its own market competitiveness. It benefits foreign companies looking to be launched on the Shanghai International Board by offering more supervision, and it makes Chinese companies more international and competitive.

Final thoughts

The occurrence of a credit crisis overseas of CCSs strengthens the recognition and development of short selling in China. SIFs landing on the CFFEX introduced short selling to China's capital markets. It is a double-edged sword which brings both profits and great risks. With short selling we face significant challenges with respect to developing the relationship between the market and the government, improving the build-up of a regulatory framework, improving the risk awareness of public investors, enhancing the qualifications of enterprises and involving international competition.

Wang He, DeHeng Law Offices, Beijing

Paying the price

Although short selling is permitted in the US, it is strictly forbidden for fraudulent actions to be committed in relation to short sales. Precedent has been set to punish those who use illegal means to obtain information to be used for short selling.

The founder of Pacific Equity Investigations, the Egypt-born Anthony Elgindy is widely known in financial circles as “Anthony@Pacific”, the “internet's most theatrical short-seller”. Elgindy was charged in January 2005 with racketeering, securities fraud and other crimes in connection with a supposed scheme to steal confidential law enforcement information relating to the FBI and SEC investigations of various companies. It was alleged that Elgindy planned to use this stolen information to include in his short selling reports and to conduct short sales. After a four-month long trial, involving allegations in 32 different stocks, Elgindy was acquitted of most of the charges against him. He was convicted of inside trading in just five of those stocks with illegal gains totaling less than US$66,000. However, at sentencing the judge used an obscure provision in the US' federal sentencing guidelines that “enhanced” Elgindy's sentence with each and every count he was acquitted of, totaling his prison time to nine years.

Spreadtrum defends against attacks

Spreadtrum Communications (Spreadtrum) is a China-based fabless semiconductor company listed in the US. It develops baseband, RF processor solutions and AVS audtio/video decoder chip solutions for the wireless communications market and the broadcast television market. Spreadtrum had listed on the Nasdaq on June 28 2007, its initial public offering price set at US$14.53. On June 28 2011, research firm Muddy Waters released a public letter to the CEO of Spreadtrum. This letter issued its doubts with the company and it issued 15 questions urging a response from Spreadtrum. This letter directly led to a slump in Spreadtrum's stock price of 34% that same day. However, a great reversal-like “V” occurred just after the plunge when Spreadtrum's share price rose again to just fall short of its pre-Muddy Waters price by 3.54% at closing. The next day, Spreadtrum commenced a telephone conference and replied to the doubts issued by Muddy Waters one by one. In the following two trading days, the stock price of the Chinese company rebounded sharply. On June 30 2011, short seller and the founder of Muddy Waters, Carson Block admitted that his research firm had misinterpreted Spreadtrum's financial reports.

Spreadtrum was able to successfully defeat the short seller's attacks because it had strong records of its standard financial data and audited matters, and it could defend against the doubts raised by pointing back at its financial data. Other Chinese companies listed in the US should follow Spreadtrum's suit and better manage its finances with independent auditing.