Don't sell the short sellers short

ACFE Cookbook: Explaining the many recipes for financial statement fraud

"The ACFE Cookbook" is devoted to examining recent cases and news involving alleged financial reporting fraud. Our focus is global, so no matter where you are, if you see news of financial reporting fraud, we'd like to hear about it for possible coverage. Send your links, news or information on public reports of alleged fraud to gzack@bdo.com. — ed.

Say what you will about short sellers, but they've played an interesting role over the years when it comes to uncovering financial statement fraud. And if recent news is any indication, this role appears to be expanding and becoming more controversial than ever.

For the uninitiated, a short seller makes money by identifying stocks he or she thinks are overvalued and then betting that the stocks' prices will fall once the market catches on. A short seller accomplishes this by borrowing shares of a stock from an investor-lender and quickly selling them at their current, inflated price. Later, when the stock's price goes down, the short seller purchases the stock and returns it to the lender, which closed the seller's "short" position.

The term "naked shorting" has nothing to do with a short seller's lifestyle but refers to the illegal practice of selling shares without having properly secured the borrowed shares first.

So, short sellers make their money by hoping a stock's price falls. Traditionally, short sellers targeted companies that they felt were overvalued for reasons having little to do with fraud — some weakness in a company's strategy, emerging competition or some other factor that the short seller picked up before anyone else did. But in recent years, the number of instances in which a short seller has claimed that a stock was overvalued because of financial statement fraud has risen quite noticeably.

A short seller claiming that a company's financial statements are fraudulent is nothing new. In 2001, one short seller had a heated exchange with Enron CEO Kenneth Lay during a conference call with company officers over the accounting positions taken in Enron's financial statements, according to "Activist Short Sellers: Market Manipulators or Market Protectors?" by Joanna Lee, Review of Banking & Financial Law, Volume 32, page 274.

Lay accused the short seller of deliberately trying to drive Enron's stock price down, and that is a company's underlying concern with information produced by short sellers. When someone has a vested interest in a stock's price falling, how accurate do his or her assertions need to be? But we all know how it turned out in the Enron case — score one point for the short sellers.

The question of whether "activist" short sellers provide a valuable service to the markets is a controversial one that's beyond the scope of this column. However, their increasing influence on the market can't be questioned. Here we'll take a look at one recent case in which a short seller was correct in asserting financial statement fraud, as well as some other recent allegations of fraud made by these new, self-appointed watchdogs.